Here's Why Takamisawa (TYO:5283) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, Takamisawa Co., Ltd. (TYO:5283) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Takamisawa

What Is Takamisawa's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Takamisawa had JP¥10.5b of debt in September 2020, down from JP¥12.5b, one year before. However, because it has a cash reserve of JP¥3.34b, its net debt is less, at about JP¥7.21b.

How Strong Is Takamisawa's Balance Sheet?

The latest balance sheet data shows that Takamisawa had liabilities of JP¥14.6b due within a year, and liabilities of JP¥7.89b falling due after that. Offsetting this, it had JP¥3.34b in cash and JP¥10.6b in receivables that were due within 12 months. So it has liabilities totalling JP¥8.56b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥3.08b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Takamisawa would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Takamisawa has a debt to EBITDA ratio of 4.0, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 15.8 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Takamisawa grew its EBIT by 6.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Takamisawa's earnings that will influence how the balance sheet holds up in the future. 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, 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. During the last three years, Takamisawa generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

While Takamisawa's level of total liabilities has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Takamisawa's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Takamisawa (at least 1 which doesn't sit too well with us) , 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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