These 4 Measures Indicate That Nippon Ichi Software (TYO:3851) Is Using Debt Safely

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Nippon Ichi Software, Inc. (TYO:3851) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Nippon Ichi Software

What Is Nippon Ichi Software's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Nippon Ichi Software had JP¥427.0m of debt, an increase on JP¥350.0m, over one year. However, it does have JP¥2.86b in cash offsetting this, leading to net cash of JP¥2.43b.

A Look At Nippon Ichi Software's Liabilities

According to the last reported balance sheet, Nippon Ichi Software had liabilities of JP¥1.35b due within 12 months, and liabilities of JP¥290.0m due beyond 12 months. On the other hand, it had cash of JP¥2.86b and JP¥481.0m worth of receivables due within a year. So it can boast JP¥1.70b more liquid assets than total liabilities.

It's good to see that Nippon Ichi Software has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Nippon Ichi Software has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Nippon Ichi Software grew its EBIT by 1,161% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Nippon Ichi Software's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Nippon Ichi Software has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Nippon Ichi Software recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Nippon Ichi Software has net cash of JP¥2.43b, as well as more liquid assets than liabilities. And we liked the look of last year's 1,161% year-on-year EBIT growth. So is Nippon Ichi Software's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 2 warning signs for Nippon Ichi Software that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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