These 4 Measures Indicate That Eidai KakoLtd (TYO:7877) Is Using Debt Safely

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. As with many other companies Eidai Kako Co.,Ltd. (TYO:7877) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Eidai KakoLtd

How Much Debt Does Eidai KakoLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Eidai KakoLtd had JP¥788.0m of debt, an increase on JP¥589.0m, over one year. However, its balance sheet shows it holds JP¥2.15b in cash, so it actually has JP¥1.36b net cash.

How Healthy Is Eidai KakoLtd's Balance Sheet?

According to the last reported balance sheet, Eidai KakoLtd had liabilities of JP¥1.18b due within 12 months, and liabilities of JP¥1.03b due beyond 12 months. Offsetting these obligations, it had cash of JP¥2.15b as well as receivables valued at JP¥1.46b due within 12 months. So it actually has JP¥1.40b more liquid assets than total liabilities.

This excess liquidity is a great indication that Eidai KakoLtd's balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that Eidai KakoLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Eidai KakoLtd's load is not too heavy, because its EBIT was down 80% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Eidai KakoLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Eidai KakoLtd 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, Eidai KakoLtd produced sturdy free cash flow equating to 79% 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 Eidai KakoLtd has JP¥1.36b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of JP¥289m, being 79% of its EBIT. So we don't think Eidai KakoLtd'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 4 warning signs with Eidai KakoLtd , and understanding them should be part of your investment process.

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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