Here's Why SAKAI HoldingsLTD (TYO:9446) Has A Meaningful Debt Burden

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies SAKAI Holdings CO.,LTD (TYO:9446) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for SAKAI HoldingsLTD

What Is SAKAI HoldingsLTD's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 SAKAI HoldingsLTD had JP¥21.4b of debt, an increase on JP¥20.3b, over one year. However, it does have JP¥5.00b in cash offsetting this, leading to net debt of about JP¥16.4b.

How Healthy Is SAKAI HoldingsLTD's Balance Sheet?

We can see from the most recent balance sheet that SAKAI HoldingsLTD had liabilities of JP¥8.17b falling due within a year, and liabilities of JP¥16.1b due beyond that. Offsetting this, it had JP¥5.00b in cash and JP¥2.52b in receivables that were due within 12 months. So it has liabilities totalling JP¥16.7b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥6.14b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, SAKAI HoldingsLTD would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

While SAKAI HoldingsLTD's debt to EBITDA ratio of 6.6 suggests a heavy debt load, its interest coverage of 8.7 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. It is well worth noting that SAKAI HoldingsLTD's EBIT shot up like bamboo after rain, gaining 53% in the last twelve months. That'll make it easier to manage 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 SAKAI HoldingsLTD 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, SAKAI HoldingsLTD reported free cash flow worth 4.1% 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

To be frank both SAKAI HoldingsLTD's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that SAKAI HoldingsLTD's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example SAKAI HoldingsLTD has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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