Here's Why Sankei Chemical (FKSE:4995) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Sankei Chemical Co., Ltd. (FKSE:4995) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sankei Chemical

How Much Debt Does Sankei Chemical Carry?

The chart below, which you can click on for greater detail, shows that Sankei Chemical had JP¥1.99b in debt in November 2020; about the same as the year before. However, it does have JP¥1.70b in cash offsetting this, leading to net debt of about JP¥287.0m.

How Healthy Is Sankei Chemical's Balance Sheet?

We can see from the most recent balance sheet that Sankei Chemical had liabilities of JP¥2.47b falling due within a year, and liabilities of JP¥1.95b due beyond that. Offsetting these obligations, it had cash of JP¥1.70b as well as receivables valued at JP¥1.52b due within 12 months. So it has liabilities totalling JP¥1.19b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of JP¥996.9m, we think shareholders really should watch Sankei Chemical's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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).

Sankei Chemical has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 39.8 times over. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Sankei Chemical grew its EBIT by 17% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Sankei Chemical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Sankei Chemical actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Both Sankei Chemical's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. Considering this range of data points, we think Sankei Chemical is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Sankei Chemical (at least 2 which are a bit unpleasant) , and understanding them should be part of your investment process.

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. 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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