Is Sophia HoldingsLtd (TYO:6942) A Risky Investment?

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.' 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. We can see that Sophia Holdings Co.,Ltd. (TYO:6942) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Sophia HoldingsLtd

What Is Sophia HoldingsLtd's Debt?

The image below, which you can click on for greater detail, shows that Sophia HoldingsLtd had debt of JP¥4.99b at the end of December 2020, a reduction from JP¥5.24b over a year. However, it does have JP¥1.91b in cash offsetting this, leading to net debt of about JP¥3.08b.

How Strong Is Sophia HoldingsLtd's Balance Sheet?

The latest balance sheet data shows that Sophia HoldingsLtd had liabilities of JP¥3.30b due within a year, and liabilities of JP¥4.06b falling due after that. Offsetting these obligations, it had cash of JP¥1.91b as well as receivables valued at JP¥1.51b due within 12 months. So its liabilities total JP¥3.95b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's JP¥3.68b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Sophia HoldingsLtd's moderate net debt to EBITDA ratio ( being 2.3), indicates prudence when it comes to debt. And its strong interest cover of 14.6 times, makes us even more comfortable. Notably, Sophia HoldingsLtd's EBIT launched higher than Elon Musk, gaining a whopping 4,392% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sophia 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent two years, Sophia HoldingsLtd recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Sophia HoldingsLtd's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Sophia HoldingsLtd's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 instance, we've identified 3 warning signs for Sophia HoldingsLtd (1 is a bit concerning) you should be aware of.

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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