Is Area Quest (TSE:8912) A Risky Investment?

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Area Quest Inc. (TSE:8912) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Area Quest

What Is Area Quest's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Area Quest had JP¥617.0m of debt, an increase on JP¥524.0m, over one year. However, it also had JP¥444.0m in cash, and so its net debt is JP¥173.0m.

A Look At Area Quest's Liabilities

According to the last reported balance sheet, Area Quest had liabilities of JP¥712.0m due within 12 months, and liabilities of JP¥1.77b due beyond 12 months. Offsetting these obligations, it had cash of JP¥444.0m as well as receivables valued at JP¥101.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥1.94b.

Given this deficit is actually higher than the company's market capitalization of JP¥1.82b, we think shareholders really should watch Area Quest's debt levels, like a parent watching their child ride a bike for the first time. 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.

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).

Area Quest's net debt is only 0.52 times its EBITDA. And its EBIT covers its interest expense a whopping 23.6 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Area Quest grew its EBIT by 6.0% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Area Quest will need earnings to service that debt. 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.

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. Looking at the most recent three years, Area Quest recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Area Quest's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Area Quest's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Area Quest is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.