Is Nankai Chemical CompanyLimited (TSE:4040) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Nankai Chemical Company,Limited (TSE:4040) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Nankai Chemical CompanyLimited

How Much Debt Does Nankai Chemical CompanyLimited Carry?

The image below, which you can click on for greater detail, shows that Nankai Chemical CompanyLimited had debt of JP¥4.73b at the end of March 2024, a reduction from JP¥6.06b over a year. However, it does have JP¥1.71b in cash offsetting this, leading to net debt of about JP¥3.02b.

How Strong Is Nankai Chemical CompanyLimited's Balance Sheet?

According to the last reported balance sheet, Nankai Chemical CompanyLimited had liabilities of JP¥7.99b due within 12 months, and liabilities of JP¥4.77b due beyond 12 months. Offsetting these obligations, it had cash of JP¥1.71b as well as receivables valued at JP¥3.90b due within 12 months. So it has liabilities totalling JP¥7.15b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of JP¥5.55b, we think shareholders really should watch Nankai Chemical CompanyLimited's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Nankai Chemical CompanyLimited has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 78.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Nankai Chemical CompanyLimited grew its EBIT by 96% over the last twelve months, and that growth will make it easier to handle its debt. 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 Nankai Chemical CompanyLimited 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Nankai Chemical CompanyLimited recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Nankai Chemical CompanyLimited's level of total liabilities has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Nankai Chemical CompanyLimited's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Nankai Chemical CompanyLimited has 4 warning signs (and 1 which makes us a bit uncomfortable) we think 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com