Komehyo HoldingsLtd (TSE:2780) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Komehyo Holdings Co.,Ltd. (TSE:2780) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Komehyo HoldingsLtd

What Is Komehyo HoldingsLtd's Debt?

As you can see below, at the end of September 2024, Komehyo HoldingsLtd had JP¥33.8b of debt, up from JP¥24.3b a year ago. Click the image for more detail. On the flip side, it has JP¥15.5b in cash leading to net debt of about JP¥18.4b.

A Look At Komehyo HoldingsLtd's Liabilities

We can see from the most recent balance sheet that Komehyo HoldingsLtd had liabilities of JP¥36.1b falling due within a year, and liabilities of JP¥7.75b due beyond that. On the other hand, it had cash of JP¥15.5b and JP¥4.41b worth of receivables due within a year. So its liabilities total JP¥23.9b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of JP¥36.9b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Komehyo HoldingsLtd's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 75.2 times, makes us even more comfortable. One way Komehyo HoldingsLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Komehyo HoldingsLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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, Komehyo HoldingsLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Komehyo HoldingsLtd's conversion of EBIT to free cash flow and level of total liabilities 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. When we consider all the factors discussed, it seems to us that Komehyo HoldingsLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 3 warning signs for Komehyo HoldingsLtd (1 is significant!) that you should be aware of before investing here.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.