These 4 Measures Indicate That Toho Chemical Industry Company (TSE:4409) Is Using Debt Extensively

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.' 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. As with many other companies Toho Chemical Industry Company, Limited (TSE:4409) makes use of debt. But is this debt a concern to shareholders?

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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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

What Is Toho Chemical Industry Company's Debt?

As you can see below, Toho Chemical Industry Company had JP¥28.5b of debt, at December 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had JP¥7.55b in cash, and so its net debt is JP¥20.9b.

How Strong Is Toho Chemical Industry Company's Balance Sheet?

We can see from the most recent balance sheet that Toho Chemical Industry Company had liabilities of JP¥25.2b falling due within a year, and liabilities of JP¥25.9b due beyond that. Offsetting these obligations, it had cash of JP¥7.55b as well as receivables valued at JP¥15.2b due within 12 months. So its liabilities total JP¥28.2b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the JP¥12.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Toho Chemical Industry Company would likely require a major re-capitalisation if it had to pay its creditors today.

Check out our latest analysis for Toho Chemical Industry Company

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).

Toho Chemical Industry Company has net debt to EBITDA of 4.5 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.7 suggests it can easily service that debt. Importantly, Toho Chemical Industry Company grew its EBIT by 73% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Toho Chemical Industry Company 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, 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, Toho Chemical Industry Company burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Toho Chemical Industry Company's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Toho Chemical Industry Company's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that Toho Chemical Industry Company is showing 4 warning signs in our investment analysis , and 2 of those don't sit too well with us...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.