These 4 Measures Indicate That Soken Chemical & Engineering (TYO:4972) Is Using Debt Safely

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Soken Chemical & Engineering Co., Ltd. (TYO:4972) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Soken Chemical & Engineering

What Is Soken Chemical & Engineering's Net Debt?

The image below, which you can click on for greater detail, shows that Soken Chemical & Engineering had debt of JP¥2.09b at the end of December 2020, a reduction from JP¥2.35b over a year. However, it does have JP¥7.83b in cash offsetting this, leading to net cash of JP¥5.74b.

How Healthy Is Soken Chemical & Engineering's Balance Sheet?

We can see from the most recent balance sheet that Soken Chemical & Engineering had liabilities of JP¥10.6b falling due within a year, and liabilities of JP¥1.93b due beyond that. Offsetting these obligations, it had cash of JP¥7.83b as well as receivables valued at JP¥9.84b due within 12 months. So it actually has JP¥5.15b more liquid assets than total liabilities.

It's good to see that Soken Chemical & Engineering has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Soken Chemical & Engineering has more cash than debt is arguably a good indication that it can manage its debt safely.

In addition to that, we're happy to report that Soken Chemical & Engineering has boosted its EBIT by 36%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Soken Chemical & Engineering's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Soken Chemical & Engineering 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. During the last three years, Soken Chemical & Engineering produced sturdy free cash flow equating to 59% 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.

Summing up

While it is always sensible to investigate a company's debt, in this case Soken Chemical & Engineering has JP¥5.74b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 36% over the last year. So is Soken Chemical & Engineering's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Soken Chemical & Engineering 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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