We Think fonfun (TYO:2323) Can Manage Its Debt With Ease

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies fonfun corporation (TYO:2323) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for fonfun

What Is fonfun's Debt?

You can click the graphic below for the historical numbers, but it shows that fonfun had JP¥243.0m of debt in December 2020, down from JP¥296.0m, one year before. However, it does have JP¥525.0m in cash offsetting this, leading to net cash of JP¥282.0m.

How Healthy Is fonfun's Balance Sheet?

The latest balance sheet data shows that fonfun had liabilities of JP¥181.0m due within a year, and liabilities of JP¥159.0m falling due after that. On the other hand, it had cash of JP¥525.0m and JP¥96.0m worth of receivables due within a year. So it actually has JP¥281.0m more liquid assets than total liabilities.

This surplus suggests that fonfun is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that fonfun has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, fonfun grew its EBIT by 311% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since fonfun 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While fonfun 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. Over the last three years, fonfun actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While it is always sensible to investigate a company's debt, in this case fonfun has JP¥282.0m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 149% of that EBIT to free cash flow, bringing in JP¥100m. So we don't think fonfun's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for fonfun that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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