Is Ultrafabrics HoldingsLtd (TYO:4235) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Ultrafabrics Holdings Co.,Ltd. (TYO:4235) makes use of debt. But the real question is whether this debt is making the company risky.

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. 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. 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.

View our latest analysis for Ultrafabrics HoldingsLtd

How Much Debt Does Ultrafabrics HoldingsLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Ultrafabrics HoldingsLtd had JP¥15.7b of debt, an increase on JP¥15.0b, over one year. However, because it has a cash reserve of JP¥3.16b, its net debt is less, at about JP¥12.5b.

How Healthy Is Ultrafabrics HoldingsLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ultrafabrics HoldingsLtd had liabilities of JP¥7.60b due within 12 months and liabilities of JP¥11.3b due beyond that. On the other hand, it had cash of JP¥3.16b and JP¥1.51b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥14.2b.

This deficit casts a shadow over the JP¥6.23b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Ultrafabrics HoldingsLtd would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Ultrafabrics HoldingsLtd shareholders face the double whammy of a high net debt to EBITDA ratio (7.1), and fairly weak interest coverage, since EBIT is just 1.1 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Ultrafabrics HoldingsLtd's EBIT was down 65% over the last year. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Ultrafabrics HoldingsLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ultrafabrics HoldingsLtd produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Ultrafabrics HoldingsLtd's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Ultrafabrics HoldingsLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Ultrafabrics HoldingsLtd has 5 warning signs (and 1 which is concerning) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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