Does Wakou Shokuhin (TSE:2813) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Wakou Shokuhin Co., Ltd. (TSE:2813) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Wakou Shokuhin

What Is Wakou Shokuhin's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Wakou Shokuhin had debt of JP¥2.66b, up from JP¥2.27b in one year. However, because it has a cash reserve of JP¥2.32b, its net debt is less, at about JP¥343.0m.

How Healthy Is Wakou Shokuhin's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Wakou Shokuhin had liabilities of JP¥4.58b due within 12 months and liabilities of JP¥1.73b due beyond that. Offsetting these obligations, it had cash of JP¥2.32b as well as receivables valued at JP¥2.77b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥1.23b.

Of course, Wakou Shokuhin has a market capitalization of JP¥10.1b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Wakou Shokuhin's net debt is only 0.21 times its EBITDA. And its EBIT covers its interest expense a whopping 173 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Wakou Shokuhin has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Wakou Shokuhin will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Wakou Shokuhin recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Wakou Shokuhin's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Overall, we don't think Wakou Shokuhin is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Wakou Shokuhin that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.