Care ServiceLtd (TYO:2425) Could Easily Take On More Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Care Service Co.,Ltd. (TYO:2425) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Care ServiceLtd

What Is Care ServiceLtd's Debt?

As you can see below, at the end of September 2020, Care ServiceLtd had JP¥637.0m of debt, up from JP¥508.0m a year ago. Click the image for more detail. But on the other hand it also has JP¥1.38b in cash, leading to a JP¥738.0m net cash position.

How Healthy Is Care ServiceLtd's Balance Sheet?

According to the last reported balance sheet, Care ServiceLtd had liabilities of JP¥1.50b due within 12 months, and liabilities of JP¥396.0m due beyond 12 months. On the other hand, it had cash of JP¥1.38b and JP¥1.34b worth of receivables due within a year. So it actually has JP¥817.0m more liquid assets than total liabilities.

This luscious liquidity implies that Care ServiceLtd's balance sheet is sturdy like a giant sequoia tree. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that Care ServiceLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Care ServiceLtd if management cannot prevent a repeat of the 51% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Care ServiceLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Care ServiceLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Care ServiceLtd 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.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Care ServiceLtd has net cash of JP¥738.0m, as well as more liquid assets than liabilities. The cherry on top was that in converted 74% of that EBIT to free cash flow, bringing in JP¥224m. So is Care ServiceLtd's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Care ServiceLtd , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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