Arakawa Chemical Industries (TSE:4968) Use Of Debt Could Be Considered Risky

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Arakawa Chemical Industries, Ltd. (TSE:4968) does use debt in its business. But the more important question is: how much risk is that debt creating?

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What Risk Does Debt Bring?

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. 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. 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.

How Much Debt Does Arakawa Chemical Industries Carry?

The chart below, which you can click on for greater detail, shows that Arakawa Chemical Industries had JP¥41.4b in debt in December 2024; about the same as the year before. However, it also had JP¥9.90b in cash, and so its net debt is JP¥31.5b.

How Healthy Is Arakawa Chemical Industries' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Arakawa Chemical Industries had liabilities of JP¥40.0b due within 12 months and liabilities of JP¥28.6b due beyond that. Offsetting these obligations, it had cash of JP¥9.90b as well as receivables valued at JP¥31.0b due within 12 months. So its liabilities total JP¥27.6b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's JP¥20.8b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

See our latest analysis for Arakawa Chemical Industries

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.2, it's fair to say Arakawa Chemical Industries does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.7 times, suggesting it can responsibly service its obligations. Notably, Arakawa Chemical Industries made a loss at the EBIT level, last year, but improved that to positive EBIT of JP¥269m in the last twelve months. 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 Arakawa Chemical Industries 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Arakawa Chemical Industries saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Arakawa Chemical Industries's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Arakawa Chemical Industries to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Arakawa Chemical Industries (1 is a bit concerning!) that you should be aware of before investing here.

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.