Here's Why Japan Tobacco (TSE:2914) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Japan Tobacco Inc. (TSE:2914) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Japan Tobacco

What Is Japan Tobacco's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Japan Tobacco had JP¥1.15t of debt, an increase on JP¥1.08t, over one year. On the flip side, it has JP¥1.09t in cash leading to net debt of about JP¥64.6b.

How Strong Is Japan Tobacco's Balance Sheet?

According to the last reported balance sheet, Japan Tobacco had liabilities of JP¥1.73t due within 12 months, and liabilities of JP¥1.61t due beyond 12 months. On the other hand, it had cash of JP¥1.09t and JP¥657.9b worth of receivables due within a year. So its liabilities total JP¥1.60t more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Japan Tobacco has a huge market capitalization of JP¥7.34t, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. But either way, Japan Tobacco has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Japan Tobacco has very modest net debt levels, with net debt at just 0.076 times EBITDA. Humorously, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt as easily as enthusiastic spray-tanners take on an orange hue. While Japan Tobacco doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Japan Tobacco can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Japan Tobacco produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Japan Tobacco's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Taking all this data into account, it seems to us that Japan Tobacco takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. We've identified 1 warning sign with Japan Tobacco , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.