Nankai Chemical CompanyLimited (TSE:4040) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Nankai Chemical Company,Limited (TSE:4040) does carry debt. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Nankai Chemical CompanyLimited

What Is Nankai Chemical CompanyLimited's Net Debt?

As you can see below, Nankai Chemical CompanyLimited had JP¥6.24b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has JP¥2.28b in cash leading to net debt of about JP¥3.97b.

How Healthy Is Nankai Chemical CompanyLimited's Balance Sheet?

The latest balance sheet data shows that Nankai Chemical CompanyLimited had liabilities of JP¥8.10b due within a year, and liabilities of JP¥4.95b falling due after that. Offsetting this, it had JP¥2.28b in cash and JP¥3.90b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥6.87b.

This deficit casts a shadow over the JP¥3.77b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Nankai Chemical CompanyLimited would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Nankai Chemical CompanyLimited's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its commanding EBIT of 96.4 times its interest expense, implies the debt load is as light as a peacock feather. Another good sign is that Nankai Chemical CompanyLimited has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Nankai Chemical CompanyLimited will need earnings to service that debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Nankai Chemical CompanyLimited's free cash flow amounted to 26% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We feel some trepidation about Nankai Chemical CompanyLimited's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Nankai Chemical CompanyLimited is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Nankai Chemical CompanyLimited is showing 2 warning signs in our investment analysis , 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.