These 4 Measures Indicate That Toyo Drilube (TYO:4976) Is Using Debt Safely

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.' 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 Toyo Drilube Co., Ltd. (TYO:4976) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Toyo Drilube

What Is Toyo Drilube's Net Debt?

As you can see below, Toyo Drilube had JP¥734.0m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have JP¥4.59b in cash offsetting this, leading to net cash of JP¥3.85b.

How Strong Is Toyo Drilube's Balance Sheet?

The latest balance sheet data shows that Toyo Drilube had liabilities of JP¥1.31b due within a year, and liabilities of JP¥597.0m falling due after that. Offsetting these obligations, it had cash of JP¥4.59b as well as receivables valued at JP¥1.10b due within 12 months. So it actually has JP¥3.79b more liquid assets than total liabilities.

This surplus liquidity suggests that Toyo Drilube's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, Toyo Drilube boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Toyo Drilube's load is not too heavy, because its EBIT was down 42% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Toyo Drilube 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 company can only pay off debt with cold hard cash, not accounting profits. Toyo Drilube 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. Over the last three years, Toyo Drilube actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to investigate a company's debt, in this case Toyo Drilube has JP¥3.85b in net cash and a strong balance sheet. And it impressed us with free cash flow of JP¥408m, being 128% of its EBIT. So is Toyo Drilube's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Toyo Drilube you should be aware of.

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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