Kao (TSE:4452) Could Easily Take On More 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Kao Corporation (TSE:4452) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Kao

How Much Debt Does Kao Carry?

As you can see below, Kao had JP¥136.2b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds JP¥304.5b in cash, so it actually has JP¥168.3b net cash.

How Strong Is Kao's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kao had liabilities of JP¥473.4b due within 12 months and liabilities of JP¥262.3b due beyond that. Offsetting these obligations, it had cash of JP¥304.5b as well as receivables valued at JP¥219.6b due within 12 months. So it has liabilities totalling JP¥211.7b more than its cash and near-term receivables, combined.

Of course, Kao has a titanic market capitalization of JP¥2.78t, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Kao also has more cash than debt, so we're pretty confident it can manage its debt safely.

Another good sign is that Kao has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Kao can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Kao may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Kao recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Kao has JP¥168.3b in net cash. And it impressed us with free cash flow of JP¥149b, being 97% of its EBIT. So is Kao's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Kao, you may well want to click here to check an interactive graph of its earnings per share history.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.