Raysum (TYO:8890) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Raysum Co., Ltd. (TYO:8890) makes use of debt. But the real question is whether this debt is making the company risky.

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Raysum

How Much Debt Does Raysum Carry?

As you can see below, at the end of December 2020, Raysum had JP¥49.7b of debt, up from JP¥33.3b a year ago. Click the image for more detail. On the flip side, it has JP¥20.6b in cash leading to net debt of about JP¥29.1b.

A Look At Raysum's Liabilities

The latest balance sheet data shows that Raysum had liabilities of JP¥8.14b due within a year, and liabilities of JP¥51.9b falling due after that. On the other hand, it had cash of JP¥20.6b and JP¥640.0m worth of receivables due within a year. So its liabilities total JP¥38.8b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's JP¥33.4b market capitalization, you might well be inclined to review the balance sheet intently. 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 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.

Raysum has a debt to EBITDA ratio of 2.5, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 34.5 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Pleasingly, Raysum is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 179% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Raysum'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Raysum saw substantial negative free cash flow, in total. 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

While Raysum's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Raysum is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Raysum (at least 1 which is concerning) , and understanding them should be part of your investment process.

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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