These 4 Measures Indicate That Daiwa House Industry (TSE:1925) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Daiwa House Industry Co., Ltd. (TSE:1925) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Daiwa House Industry

What Is Daiwa House Industry's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Daiwa House Industry had debt of JP¥2.24t, up from JP¥2.13t in one year. However, because it has a cash reserve of JP¥379.9b, its net debt is less, at about JP¥1.86t.

How Healthy Is Daiwa House Industry's Balance Sheet?

According to the last reported balance sheet, Daiwa House Industry had liabilities of JP¥1.60t due within 12 months, and liabilities of JP¥2.39t due beyond 12 months. Offsetting this, it had JP¥379.9b in cash and JP¥546.5b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥3.06t.

When you consider that this deficiency exceeds the company's huge JP¥2.90t 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.

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

Daiwa House Industry's net debt is 2.9 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 26.1 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Daiwa House Industry grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. 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 Daiwa House Industry 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Daiwa House Industry saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Daiwa House Industry's conversion of EBIT to free cash flow has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Daiwa House Industry is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Daiwa House Industry (of which 2 are potentially serious!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.