These 4 Measures Indicate That Mullion (TSE:3494) Is Using Debt In A Risky Way

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Mullion Co., Ltd. (TSE:3494) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Mullion

What Is Mullion's Net Debt?

As you can see below, Mullion had JP¥8.81b of debt at June 2024, down from JP¥9.21b a year prior. However, it does have JP¥1.07b in cash offsetting this, leading to net debt of about JP¥7.74b.

How Healthy Is Mullion's Balance Sheet?

We can see from the most recent balance sheet that Mullion had liabilities of JP¥1.32b falling due within a year, and liabilities of JP¥13.0b due beyond that. Offsetting this, it had JP¥1.07b in cash and JP¥88.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥13.1b.

This deficit casts a shadow over the JP¥3.18b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Mullion would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 13.7, it's fair to say Mullion does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.7 times, suggesting it can responsibly service its obligations. Another concern for investors might be that Mullion's EBIT fell 19% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But it is Mullion's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Mullion burned a lot of cash. 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

To be frank both Mullion's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its EBIT growth rate also fails to instill confidence. It looks to us like Mullion carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Mullion (of which 3 are concerning!) 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.