Is Ultrafabrics HoldingsLtd (TSE:4235) A Risky Investment?

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. Importantly, Ultrafabrics Holdings Co.,Ltd. (TSE:4235) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Ultrafabrics HoldingsLtd

What Is Ultrafabrics HoldingsLtd's Debt?

As you can see below, Ultrafabrics HoldingsLtd had JP¥16.0b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of JP¥2.75b, its net debt is less, at about JP¥13.3b.

A Look At Ultrafabrics HoldingsLtd's Liabilities

The latest balance sheet data shows that Ultrafabrics HoldingsLtd had liabilities of JP¥11.7b due within a year, and liabilities of JP¥9.08b falling due after that. Offsetting these obligations, it had cash of JP¥2.75b as well as receivables valued at JP¥3.41b due within 12 months. So it has liabilities totalling JP¥14.6b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of JP¥18.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Ultrafabrics HoldingsLtd's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 6.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The bad news is that Ultrafabrics HoldingsLtd saw its EBIT decline by 18% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ultrafabrics HoldingsLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Ultrafabrics HoldingsLtd recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Ultrafabrics HoldingsLtd's EBIT growth rate was disappointing. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that Ultrafabrics HoldingsLtd's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Ultrafabrics HoldingsLtd (including 1 which is potentially serious) .

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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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.

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