cottaLTD (TSE:3359) Has A Pretty Healthy Balance Sheet

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that cotta CO.,LTD (TSE:3359) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for cottaLTD

How Much Debt Does cottaLTD Carry?

The image below, which you can click on for greater detail, shows that cottaLTD had debt of JP¥1.16b at the end of June 2024, a reduction from JP¥1.33b over a year. However, its balance sheet shows it holds JP¥2.30b in cash, so it actually has JP¥1.14b net cash.

A Look At cottaLTD's Liabilities

The latest balance sheet data shows that cottaLTD had liabilities of JP¥1.91b due within a year, and liabilities of JP¥248.0m falling due after that. On the other hand, it had cash of JP¥2.30b and JP¥374.0m worth of receivables due within a year. So it can boast JP¥510.0m more liquid assets than total liabilities.

This surplus suggests that cottaLTD has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that cottaLTD 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 cottaLTD if management cannot prevent a repeat of the 21% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if cottaLTD can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While cottaLTD 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, cottaLTD produced sturdy free cash flow equating to 58% 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 we empathize with investors who find debt concerning, you should keep in mind that cottaLTD has net cash of JP¥1.14b, as well as more liquid assets than liabilities. So we don't have any problem with cottaLTD's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for cottaLTD 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.