Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Eidai Kako Co.,Ltd. (TYO:7877) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Eidai KakoLtd Carry?
The image below, which you can click on for greater detail, shows that at December 2020 Eidai KakoLtd had debt of JP¥779.0m, up from JP¥617.0m in one year. But it also has JP¥2.26b in cash to offset that, meaning it has JP¥1.48b net cash.
How Strong Is Eidai KakoLtd's Balance Sheet?
According to the last reported balance sheet, Eidai KakoLtd had liabilities of JP¥1.70b due within 12 months, and liabilities of JP¥996.0m due beyond 12 months. Offsetting these obligations, it had cash of JP¥2.26b as well as receivables valued at JP¥1.86b due within 12 months. So it can boast JP¥1.42b more liquid assets than total liabilities.
This surplus liquidity suggests that Eidai KakoLtd's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Eidai KakoLtd has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Eidai KakoLtd if management cannot prevent a repeat of the 35% cut to EBIT 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. While Eidai KakoLtd 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. During the last three years, Eidai KakoLtd produced sturdy free cash flow equating to 69% 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.
While we empathize with investors who find debt concerning, you should keep in mind that Eidai KakoLtd has net cash of JP¥1.48b, as well as more liquid assets than liabilities. The cherry on top was that in converted 69% of that EBIT to free cash flow, bringing in JP¥289m. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Eidai KakoLtd that you should be aware of before investing here.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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