These 4 Measures Indicate That NAFCO (TYO:2790) Is Using Debt Reasonably Well

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that NAFCO Co., Ltd. (TYO:2790) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for NAFCO

What Is NAFCO's Net Debt?

As you can see below, NAFCO had JP¥22.4b of debt at September 2020, down from JP¥29.0b a year prior. However, it does have JP¥42.5b in cash offsetting this, leading to net cash of JP¥20.1b.

How Healthy Is NAFCO's Balance Sheet?

We can see from the most recent balance sheet that NAFCO had liabilities of JP¥73.9b falling due within a year, and liabilities of JP¥12.4b due beyond that. Offsetting these obligations, it had cash of JP¥42.5b as well as receivables valued at JP¥3.19b due within 12 months. So it has liabilities totalling JP¥40.6b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of JP¥60.2b. 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 122% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since NAFCO will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While NAFCO has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, NAFCO generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing up

While NAFCO does have more liabilities than liquid assets, it also has net cash of JP¥20.1b. And it impressed us with free cash flow of JP¥20b, being 92% 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.

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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