These 4 Measures Indicate That Sanyo Special Steel (TSE:5481) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Sanyo Special Steel Co., Ltd. (TSE:5481) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Sanyo Special Steel

What Is Sanyo Special Steel's Net Debt?

The image below, which you can click on for greater detail, shows that Sanyo Special Steel had debt of JP¥91.9b at the end of December 2023, a reduction from JP¥98.6b over a year. However, because it has a cash reserve of JP¥33.0b, its net debt is less, at about JP¥58.9b.

A Look At Sanyo Special Steel's Liabilities

The latest balance sheet data shows that Sanyo Special Steel had liabilities of JP¥141.4b due within a year, and liabilities of JP¥29.8b falling due after that. On the other hand, it had cash of JP¥33.0b and JP¥72.7b worth of receivables due within a year. So it has liabilities totalling JP¥65.5b more than its cash and near-term receivables, combined.

Sanyo Special Steel has a market capitalization of JP¥126.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Sanyo Special Steel's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 19.5 times, makes us even more comfortable. Importantly, Sanyo Special Steel's EBIT fell a jaw-dropping 38% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sanyo Special Steel'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sanyo Special Steel barely recorded positive free cash flow, in total. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

We'd go so far as to say Sanyo Special Steel's EBIT growth rate was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sanyo Special Steel stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Sanyo Special Steel that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.