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 Meiho Enterprise Co., Ltd. (TYO:8927) does use debt in its business. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Meiho Enterprise Carry?
As you can see below, Meiho Enterprise had JP¥5.19b of debt at October 2020, down from JP¥5.82b a year prior. On the flip side, it has JP¥1.44b in cash leading to net debt of about JP¥3.75b.
A Look At Meiho Enterprise's Liabilities
We can see from the most recent balance sheet that Meiho Enterprise had liabilities of JP¥4.03b falling due within a year, and liabilities of JP¥2.30b due beyond that. Offsetting this, it had JP¥1.44b in cash and JP¥1.58b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥3.31b.
This deficit is considerable relative to its market capitalization of JP¥4.70b, so it does suggest shareholders should keep an eye on Meiho Enterprise's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Meiho Enterprise's net debt to EBITDA ratio is 6.0 which suggests rather high debt levels, but its interest cover of 8.0 times suggests the debt is easily serviced. Our best guess is that the company does indeed have significant debt obligations. We note that Meiho Enterprise grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Meiho Enterprise'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Meiho Enterprise recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Based on what we've seen Meiho Enterprise is not finding it easy, given its net debt to EBITDA, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Meiho Enterprise is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example Meiho Enterprise has 4 warning signs (and 1 which is a bit unpleasant) we think 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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