These 4 Measures Indicate That Kaneka (TSE:4118) Is Using Debt Extensively
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.' 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. We can see that Kaneka Corporation (TSE:4118) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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What Is Kaneka's Debt?
The image below, which you can click on for greater detail, shows that at March 2024 Kaneka had debt of JP„176.9b, up from JP„160.2b in one year. However, because it has a cash reserve of JP„44.0b, its net debt is less, at about JP„133.0b.
How Strong Is Kaneka's Balance Sheet?
According to the last reported balance sheet, Kaneka had liabilities of JP„291.7b due within 12 months, and liabilities of JP„104.2b due beyond 12 months. Offsetting this, it had JP„44.0b in cash and JP„184.5b in receivables that were due within 12 months. So its liabilities total JP„167.4b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of JP„243.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
We'd say that Kaneka's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its strong interest cover of 23.6 times, makes us even more comfortable. Unfortunately, Kaneka saw its EBIT slide 7.5% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Kaneka 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Kaneka burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Mulling over Kaneka's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Kaneka's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Kaneka has 1 warning sign we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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About TSE:4118
Kaneka
Engages in the manufacture and sale of polyvinyl chloride (PVC), crosslinked PVC, PVC-PVAc polymers, paste PVC, acryl grafted-vinyl chloride copolymer, and chlorinated PVC in Japan and internationally.
Undervalued with solid track record.