Tokai Carbon (TSE:5301) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Tokai Carbon Co., Ltd. (TSE:5301) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Tokai Carbon

How Much Debt Does Tokai Carbon Carry?

As you can see below, Tokai Carbon had JP¥178.6b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has JP¥77.4b in cash leading to net debt of about JP¥101.2b.

How Healthy Is Tokai Carbon's Balance Sheet?

The latest balance sheet data shows that Tokai Carbon had liabilities of JP¥124.1b due within a year, and liabilities of JP¥169.6b falling due after that. Offsetting these obligations, it had cash of JP¥77.4b as well as receivables valued at JP¥72.6b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥143.7b.

This is a mountain of leverage relative to its market capitalization of JP¥178.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Tokai Carbon's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. In fact Tokai Carbon's saving grace is its low debt levels, because its EBIT has tanked 44% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Tokai Carbon 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tokai Carbon reported free cash flow worth 7.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Tokai Carbon's EBIT growth rate was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that Tokai Carbon has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Tokai Carbon , and understanding them should be part of your investment process.

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.