Here's Why NAFCO (TYO:2790) Can Manage Its Debt Responsibly

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 NAFCO Co., Ltd. (TYO:2790) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for NAFCO

What Is NAFCO's Debt?

As you can see below, NAFCO had JP¥22.4b of debt at December 2020, down from JP¥27.4b a year prior. However, its balance sheet shows it holds JP¥46.1b in cash, so it actually has JP¥23.7b net cash.

How Strong Is NAFCO's Balance Sheet?

According to the last reported balance sheet, NAFCO had liabilities of JP¥77.8b due within 12 months, and liabilities of JP¥12.4b due beyond 12 months. Offsetting this, it had JP¥46.1b in cash and JP¥3.80b in receivables that were due within 12 months. So it has liabilities totalling JP¥40.3b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of JP¥61.4b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, NAFCO also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, NAFCO grew its EBIT by 167% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is NAFCO's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. NAFCO may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, NAFCO recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While NAFCO does have more liabilities than liquid assets, it also has net cash of JP¥23.7b. And it impressed us with free cash flow of JP¥20b, being 88% of its EBIT. So we don't think NAFCO's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of NAFCO's earnings per share history for free.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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