We Think Daiwa House Industry (TSE:1925) Is Taking Some Risk With Its Debt

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. As with many other companies Daiwa House Industry Co., Ltd. (TSE:1925) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Daiwa House Industry

What Is Daiwa House Industry's Net Debt?

As you can see below, at the end of September 2024, Daiwa House Industry had JP¥2.32t of debt, up from JP¥2.03t a year ago. Click the image for more detail. However, it also had JP¥528.9b in cash, and so its net debt is JP¥1.80t.

How Healthy Is Daiwa House Industry's Balance Sheet?

According to the last reported balance sheet, Daiwa House Industry had liabilities of JP¥1.66t due within 12 months, and liabilities of JP¥2.57t due beyond 12 months. Offsetting these obligations, it had cash of JP¥528.9b as well as receivables valued at JP¥517.6b due within 12 months. So its liabilities total JP¥3.18t more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's massive market capitalization of JP¥3.08t, we think shareholders really should watch Daiwa House Industry's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

Daiwa House Industry has a debt to EBITDA ratio of 3.0, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 16.8 is very high, suggesting that the interest expense on the debt is currently quite low. Unfortunately, Daiwa House Industry saw its EBIT slide 3.6% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Daiwa House Industry's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Mulling over Daiwa House Industry's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Daiwa House Industry's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Daiwa House Industry (of which 1 is potentially serious!) you should know about.

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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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.