Cosmos Initia (TYO:8844) Seems To Be Using A Lot Of Debt

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.' 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, Cosmos Initia Co., Ltd. (TYO:8844) does carry debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Cosmos Initia

How Much Debt Does Cosmos Initia Carry?

As you can see below, Cosmos Initia had JP¥87.2b of debt at December 2020, down from JP¥93.0b a year prior. On the flip side, it has JP¥21.0b in cash leading to net debt of about JP¥66.2b.

How Strong Is Cosmos Initia's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cosmos Initia had liabilities of JP¥76.7b due within 12 months and liabilities of JP¥37.5b due beyond that. Offsetting this, it had JP¥21.0b in cash and JP¥1.28b in receivables that were due within 12 months. So its liabilities total JP¥91.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the JP¥14.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Cosmos Initia 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). 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).

As it happens Cosmos Initia has a fairly concerning net debt to EBITDA ratio of 30.3 but very strong interest coverage of 29.5. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Cosmos Initia's EBIT fell a jaw-dropping 62% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Cosmos Initia'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Cosmos Initia burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Cosmos Initia's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We think the chances that Cosmos Initia has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Case in point: We've spotted 3 warning signs for Cosmos Initia you should be aware of, and 2 of them shouldn't be ignored.

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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This article by Simply Wall St is general in nature. 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.
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