We Think NEW ART HOLDINGS (TYO:7638) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 NEW ART HOLDINGS Co., Ltd. (TYO:7638) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for NEW ART HOLDINGS

How Much Debt Does NEW ART HOLDINGS Carry?

The image below, which you can click on for greater detail, shows that NEW ART HOLDINGS had debt of JP¥5.42b at the end of December 2020, a reduction from JP¥6.54b over a year. However, because it has a cash reserve of JP¥3.23b, its net debt is less, at about JP¥2.19b.

How Strong Is NEW ART HOLDINGS' Balance Sheet?

The latest balance sheet data shows that NEW ART HOLDINGS had liabilities of JP¥8.38b due within a year, and liabilities of JP¥1.90b falling due after that. Offsetting these obligations, it had cash of JP¥3.23b as well as receivables valued at JP¥1.49b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥5.56b.

NEW ART HOLDINGS has a market capitalization of JP¥16.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

NEW ART HOLDINGS's net debt is only 0.74 times its EBITDA. And its EBIT easily covers its interest expense, being 40.3 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that NEW ART HOLDINGS's load is not too heavy, because its EBIT was down 22% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is NEW ART HOLDINGS'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, NEW ART HOLDINGS reported free cash flow worth 19% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

NEW ART HOLDINGS's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think NEW ART HOLDINGS's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example NEW ART HOLDINGS has 2 warning signs (and 1 which is potentially serious) we think 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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