Sk KakenLtd (TYO:4628) Could Easily Take On More Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Sk Kaken Co.,Ltd. (TYO:4628) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Sk KakenLtd

What Is Sk KakenLtd's Net Debt?

As you can see below, Sk KakenLtd had JP¥3.00b of debt at September 2020, down from JP¥3.13b a year prior. But on the other hand it also has JP¥96.8b in cash, leading to a JP¥93.8b net cash position.

A Look At Sk KakenLtd's Liabilities

We can see from the most recent balance sheet that Sk KakenLtd had liabilities of JP¥17.1b falling due within a year, and liabilities of JP¥3.43b due beyond that. On the other hand, it had cash of JP¥96.8b and JP¥16.9b worth of receivables due within a year. So it actually has JP¥93.2b more liquid assets than total liabilities.

This surplus strongly suggests that Sk KakenLtd has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Sk KakenLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Sk KakenLtd's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Sk KakenLtd will need earnings to service that debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Sk KakenLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Sk KakenLtd recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Sk KakenLtd has net cash of JP¥93.8b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of JP¥8.8b, being 89% of its EBIT. So we don't think Sk KakenLtd's use of debt is risky. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Sk KakenLtd , 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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