These 4 Measures Indicate That Sumitomo Bakelite (TSE:4203) Is Using Debt Safely

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Sumitomo Bakelite Company Limited (TSE:4203) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Sumitomo Bakelite

What Is Sumitomo Bakelite's Net Debt?

As you can see below, Sumitomo Bakelite had JP¥38.3b of debt at June 2024, down from JP¥49.5b a year prior. But on the other hand it also has JP¥116.6b in cash, leading to a JP¥78.2b net cash position.

A Look At Sumitomo Bakelite's Liabilities

According to the last reported balance sheet, Sumitomo Bakelite had liabilities of JP¥82.4b due within 12 months, and liabilities of JP¥45.8b due beyond 12 months. Offsetting these obligations, it had cash of JP¥116.6b as well as receivables valued at JP¥65.3b due within 12 months. So it can boast JP¥53.7b more liquid assets than total liabilities.

This short term liquidity is a sign that Sumitomo Bakelite could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Sumitomo Bakelite has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that Sumitomo Bakelite grew its EBIT at 17% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sumitomo Bakelite's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Sumitomo Bakelite has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Sumitomo Bakelite produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Sumitomo Bakelite has JP¥78.2b in net cash and a decent-looking balance sheet. And we liked the look of last year's 17% year-on-year EBIT growth. So is Sumitomo Bakelite's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Sumitomo Bakelite , and understanding them should be part of your investment process.

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.