Is Mental Health TechnologiesLtd (TSE:9218) Using Too Much 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.' 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. We can see that Mental Health Technologies Co.,Ltd. (TSE:9218) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Mental Health TechnologiesLtd

How Much Debt Does Mental Health TechnologiesLtd Carry?

As you can see below, at the end of June 2024, Mental Health TechnologiesLtd had JP¥2.56b of debt, up from JP¥381.0m a year ago. Click the image for more detail. However, because it has a cash reserve of JP¥1.06b, its net debt is less, at about JP¥1.50b.

How Healthy Is Mental Health TechnologiesLtd's Balance Sheet?

According to the last reported balance sheet, Mental Health TechnologiesLtd had liabilities of JP¥948.0m due within 12 months, and liabilities of JP¥2.21b due beyond 12 months. Offsetting these obligations, it had cash of JP¥1.06b as well as receivables valued at JP¥647.0m due within 12 months. So its liabilities total JP¥1.46b more than the combination of its cash and short-term receivables.

Mental Health TechnologiesLtd has a market capitalization of JP¥7.24b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Mental Health TechnologiesLtd has a sky high EBITDA ratio of 5.9, implying high debt, but a strong interest coverage of 12.5. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Mental Health TechnologiesLtd's EBIT fell a jaw-dropping 31% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Mental Health TechnologiesLtd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Mental Health TechnologiesLtd produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Mental Health TechnologiesLtd's EBIT growth rate and net debt to EBITDA definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We should also note that Healthcare Services industry companies like Mental Health TechnologiesLtd commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Mental Health TechnologiesLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 5 warning signs for Mental Health TechnologiesLtd (1 doesn't sit too well with us!) 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.