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.' 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. We note that Applied Co.,Ltd. (TYO:3020) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for AppliedLtd
What Is AppliedLtd's Net Debt?
The image below, which you can click on for greater detail, shows that AppliedLtd had debt of JP¥2.50b at the end of September 2020, a reduction from JP¥3.76b over a year. However, it also had JP¥2.12b in cash, and so its net debt is JP¥380.0m.
How Strong Is AppliedLtd's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that AppliedLtd had liabilities of JP¥5.39b due within 12 months and liabilities of JP¥2.37b due beyond that. On the other hand, it had cash of JP¥2.12b and JP¥6.54b worth of receivables due within a year. So it actually has JP¥894.0m more liquid assets than total liabilities.
This short term liquidity is a sign that AppliedLtd could probably pay off its debt with ease, as its balance sheet is far from stretched.
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). 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).
AppliedLtd has a low net debt to EBITDA ratio of only 0.14. And its EBIT covers its interest expense a whopping 164 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, AppliedLtd grew its EBIT by 57% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since AppliedLtd 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, 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. In the last three years, AppliedLtd's free cash flow amounted to 50% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
AppliedLtd's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that AppliedLtd is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 4 warning signs for AppliedLtd you should know about.
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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About TSE:3020
Flawless balance sheet, good value and pays a dividend.
