Is KowaLtd (TYO:7807) A Risky Investment?

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.' 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 can see that Kowa Co.,Ltd. (TYO:7807) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

Check out our latest analysis for KowaLtd

What Is KowaLtd's Debt?

The image below, which you can click on for greater detail, shows that KowaLtd had debt of JP¥2.63b at the end of November 2020, a reduction from JP¥3.74b over a year. On the flip side, it has JP¥2.06b in cash leading to net debt of about JP¥573.0m.

How Healthy Is KowaLtd's Balance Sheet?

According to the last reported balance sheet, KowaLtd had liabilities of JP¥1.61b due within 12 months, and liabilities of JP¥2.68b due beyond 12 months. Offsetting these obligations, it had cash of JP¥2.06b as well as receivables valued at JP¥836.0m due within 12 months. So its liabilities total JP¥1.40b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because KowaLtd is worth JP¥4.40b, and thus could probably raise enough capital to shore up 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.

Looking at its net debt to EBITDA of 1.2 and interest cover of 3.3 times, it seems to us that KowaLtd is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that KowaLtd improved its EBIT from a last year's loss to a positive JP¥127m. There's no doubt that we learn most about debt from the balance sheet. But it is KowaLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, KowaLtd recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

KowaLtd's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that KowaLtd 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. 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 3 warning signs with KowaLtd (at least 1 which doesn't sit too well with us) , 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. 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.
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