These 4 Measures Indicate That Mullion (TYO:3494) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Mullion Co., Ltd. (TYO:3494) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Mullion

What Is Mullion's Net Debt?

The image below, which you can click on for greater detail, shows that Mullion had debt of JP¥6.30b at the end of December 2020, a reduction from JP¥7.70b over a year. However, it also had JP¥431.0m in cash, and so its net debt is JP¥5.87b.

A Look At Mullion's Liabilities

According to the last reported balance sheet, Mullion had liabilities of JP¥2.26b due within 12 months, and liabilities of JP¥9.11b due beyond 12 months. On the other hand, it had cash of JP¥431.0m and -JP¥1.00m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥10.9b.

This deficit casts a shadow over the JP¥2.21b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Mullion would probably need a major re-capitalization if its creditors were to demand repayment.

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

Mullion's net debt to EBITDA ratio is 7.2 which suggests rather high debt levels, but its interest cover of 8.2 times suggests the debt is easily serviced. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. It is well worth noting that Mullion's EBIT shot up like bamboo after rain, gaining 39% in the last twelve months. That'll make it easier to manage its debt. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Mullion actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

While Mullion's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. We think that Mullion's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 3 warning signs for Mullion you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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