Is MegaChips (TSE:6875) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies MegaChips Corporation (TSE:6875) makes use of debt. But is this debt a concern to shareholders?

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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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does MegaChips Carry?

The image below, which you can click on for greater detail, shows that at December 2024 MegaChips had debt of JP¥6.00b, up from none in one year. But it also has JP¥14.7b in cash to offset that, meaning it has JP¥8.74b net cash.

How Healthy Is MegaChips' Balance Sheet?

We can see from the most recent balance sheet that MegaChips had liabilities of JP¥13.4b falling due within a year, and liabilities of JP¥37.9b due beyond that. Offsetting these obligations, it had cash of JP¥14.7b as well as receivables valued at JP¥26.3b due within 12 months. So its liabilities total JP¥10.3b more than the combination of its cash and short-term receivables.

Since publicly traded MegaChips shares are worth a total of JP¥79.1b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, MegaChips also has more cash than debt, so we're pretty confident it can manage its debt safely.

View our latest analysis for MegaChips

In fact MegaChips's saving grace is its low debt levels, because its EBIT has tanked 39% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine MegaChips's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While MegaChips has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, MegaChips's free cash flow amounted to 33% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While MegaChips does have more liabilities than liquid assets, it also has net cash of JP¥8.74b. So we are not troubled with MegaChips's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for MegaChips (of which 1 is a bit concerning!) 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. 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.