Nankai Chemical CompanyLimited (TSE:4040) Seems To Be Using A Lot Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 the more important question is: how much risk is that debt creating?

We've discovered 3 warning signs about Nankai Chemical CompanyLimited. View them for free.

What Risk Does Debt Bring?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Nankai Chemical CompanyLimited's Debt?

As you can see below, at the end of December 2024, Nankai Chemical CompanyLimited had JP¥6.27b of debt, up from JP¥4.87b a year ago. Click the image for more detail. However, because it has a cash reserve of JP¥1.61b, its net debt is less, at about JP¥4.67b.

How Strong Is Nankai Chemical CompanyLimited's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Nankai Chemical CompanyLimited had liabilities of JP¥8.86b due within 12 months and liabilities of JP¥5.50b due beyond that. On the other hand, it had cash of JP¥1.61b and JP¥4.48b worth of receivables due within a year. So its liabilities total JP¥8.28b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of JP¥6.25b, 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. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

Check out our latest analysis for Nankai Chemical CompanyLimited

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Nankai Chemical CompanyLimited's moderate net debt to EBITDA ratio ( being 2.0), indicates prudence when it comes to debt. And its commanding EBIT of 51.9 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Nankai Chemical CompanyLimited's EBIT fell a jaw-dropping 24% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Nankai Chemical CompanyLimited actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

On the face of it, Nankai Chemical CompanyLimited's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Nankai Chemical CompanyLimited to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 3 warning signs for Nankai Chemical CompanyLimited (2 are concerning!) 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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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.