These 4 Measures Indicate That Sagami Rubber Industries (TSE:5194) Is Using Debt Extensively

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.' 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 note that Sagami Rubber Industries Co., Ltd. (TSE:5194) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sagami Rubber Industries

What Is Sagami Rubber Industries's Debt?

The image below, which you can click on for greater detail, shows that Sagami Rubber Industries had debt of JP¥5.74b at the end of March 2024, a reduction from JP¥6.41b over a year. However, it does have JP¥1.19b in cash offsetting this, leading to net debt of about JP¥4.55b.

How Healthy Is Sagami Rubber Industries' Balance Sheet?

According to the last reported balance sheet, Sagami Rubber Industries had liabilities of JP¥6.72b due within 12 months, and liabilities of JP¥898.0m due beyond 12 months. Offsetting this, it had JP¥1.19b in cash and JP¥2.43b in receivables that were due within 12 months. So it has liabilities totalling JP¥3.99b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Sagami Rubber Industries has a market capitalization of JP¥10.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Sagami Rubber Industries has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Sagami Rubber Industries saw its EBIT tank 34% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Sagami Rubber Industries 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.

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. During the last three years, Sagami Rubber Industries produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say Sagami Rubber Industries's EBIT growth rate was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sagami Rubber Industries stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Sagami Rubber Industries (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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