These 4 Measures Indicate That Koken (TYO:7963) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Koken Ltd. (TYO:7963) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Koken

What Is Koken's Debt?

As you can see below, Koken had JP¥5.46b of debt at September 2020, down from JP¥6.22b a year prior. On the flip side, it has JP¥1.82b in cash leading to net debt of about JP¥3.64b.

How Healthy Is Koken's Balance Sheet?

The latest balance sheet data shows that Koken had liabilities of JP¥4.12b due within a year, and liabilities of JP¥4.39b falling due after that. Offsetting this, it had JP¥1.82b in cash and JP¥2.60b in receivables that were due within 12 months. So its liabilities total JP¥4.09b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Koken has a market capitalization of JP¥11.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Koken's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 26.2 times, makes us even more comfortable. Notably, Koken's EBIT launched higher than Elon Musk, gaining a whopping 157% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is Koken'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Koken saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Based on what we've seen Koken is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. We would also note that Medical Equipment industry companies like Koken commonly do use debt without problems. Considering this range of data points, we think Koken is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Koken , 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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