Is Pacific NetLtd (TSE:3021) Using Too Much Debt?

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. As with many other companies Pacific Net Co.,Ltd. (TSE:3021) makes use of debt. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Pacific NetLtd

What Is Pacific NetLtd's Debt?

The image below, which you can click on for greater detail, shows that at February 2024 Pacific NetLtd had debt of JP¥5.27b, up from JP¥3.91b in one year. However, because it has a cash reserve of JP¥1.10b, its net debt is less, at about JP¥4.17b.

A Look At Pacific NetLtd's Liabilities

According to the last reported balance sheet, Pacific NetLtd had liabilities of JP¥2.97b due within 12 months, and liabilities of JP¥3.36b due beyond 12 months. Offsetting this, it had JP¥1.10b in cash and JP¥585.0m in receivables that were due within 12 months. So it has liabilities totalling JP¥4.65b more than its cash and near-term receivables, combined.

Pacific NetLtd has a market capitalization of JP¥8.29b, 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 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).

Pacific NetLtd's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 20.5 times its interest expense, implies the debt load is as light as a peacock feather. On top of that, Pacific NetLtd grew its EBIT by 54% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Pacific NetLtd'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Pacific NetLtd burned a lot of cash. 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

Based on what we've seen Pacific NetLtd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Pacific NetLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should learn about the 5 warning signs we've spotted with Pacific NetLtd (including 1 which is concerning) .

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. 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.

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