Here's Why Air Water (TSE:4088) Has A Meaningful Debt Burden

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.' 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. As with many other companies Air Water Inc. (TSE:4088) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Air Water

What Is Air Water's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Air Water had debt of JP¥418.7b, up from JP¥366.7b in one year. However, it does have JP¥65.0b in cash offsetting this, leading to net debt of about JP¥353.7b.

A Look At Air Water's Liabilities

We can see from the most recent balance sheet that Air Water had liabilities of JP¥317.5b falling due within a year, and liabilities of JP¥396.7b due beyond that. On the other hand, it had cash of JP¥65.0b and JP¥243.0b worth of receivables due within a year. So it has liabilities totalling JP¥406.2b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of JP¥489.4b, so it does suggest shareholders should keep an eye on Air Water's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Air Water has a debt to EBITDA ratio of 3.1, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 42.4 is very high, suggesting that the interest expense on the debt is currently quite low. We note that Air Water grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Air Water can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Air Water created free cash flow amounting to 16% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Even if we have reservations about how easily Air Water is capable of converting EBIT to free cash flow, its interest cover and EBIT growth rate make us think feel relatively unconcerned. Looking at all the angles mentioned above, it does seem to us that Air Water is a somewhat risky investment as a result of its debt. 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. Case in point: We've spotted 2 warning signs for Air Water you should be aware of, and 1 of them is a bit concerning.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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