Is Hokko Chemical Industry (TSE:4992) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Hokko Chemical Industry Co., Ltd. (TSE:4992) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hokko Chemical Industry

How Much Debt Does Hokko Chemical Industry Carry?

The chart below, which you can click on for greater detail, shows that Hokko Chemical Industry had JP¥5.90b in debt in May 2024; about the same as the year before. On the flip side, it has JP¥2.42b in cash leading to net debt of about JP¥3.48b.

How Strong Is Hokko Chemical Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hokko Chemical Industry had liabilities of JP¥17.8b due within 12 months and liabilities of JP¥10.5b due beyond that. Offsetting this, it had JP¥2.42b in cash and JP¥26.3b in receivables that were due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to Hokko Chemical Industry's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the JP¥38.1b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hokko Chemical Industry has a low debt to EBITDA ratio of only 0.58. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. But the bad news is that Hokko Chemical Industry has seen its EBIT plunge 19% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Hokko Chemical Industry's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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 that EBIT is backed by free cash flow. Looking at the most recent three years, Hokko Chemical Industry recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Hokko Chemical Industry was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, EBIT growth rate gives us cold feet. Looking at all this data makes us feel a little cautious about Hokko Chemical Industry's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Hokko Chemical Industry (of which 1 is potentially serious!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com