Is Kawamoto (TSE:3604) Using Too Much Debt?

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. Importantly, Kawamoto Corporation (TSE:3604) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Kawamoto

How Much Debt Does Kawamoto Carry?

As you can see below, Kawamoto had JP¥6.41b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of JP¥1.50b, its net debt is less, at about JP¥4.91b.

A Look At Kawamoto's Liabilities

According to the last reported balance sheet, Kawamoto had liabilities of JP¥9.11b due within 12 months, and liabilities of JP¥3.29b due beyond 12 months. Offsetting this, it had JP¥1.50b in cash and JP¥10.0b in receivables that were due within 12 months. So it has liabilities totalling JP¥891.0m more than its cash and near-term receivables, combined.

Given Kawamoto has a market capitalization of JP¥5.53b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

As it happens Kawamoto has a fairly concerning net debt to EBITDA ratio of 5.4 but very strong interest coverage of 68.2. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. One way Kawamoto could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 20%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kawamoto will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Kawamoto created free cash flow amounting to 9.5% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Kawamoto was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, net debt to EBITDA gives us cold feet. It's also worth noting that Kawamoto is in the Medical Equipment industry, which is often considered to be quite defensive. Considering this range of data points, we think Kawamoto is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 6 warning signs for Kawamoto (2 make us uncomfortable!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.