Fabrica Holdings (TSE:4193) Seems To Use Debt Quite Sensibly

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 Fabrica Holdings Co., Ltd. (TSE:4193) 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?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Fabrica Holdings

What Is Fabrica Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Fabrica Holdings had debt of JP¥282.6m, up from JP¥226.0m in one year. But on the other hand it also has JP¥2.10b in cash, leading to a JP¥1.82b net cash position.

A Look At Fabrica Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Fabrica Holdings had liabilities of JP¥1.40b due within 12 months and liabilities of JP¥308.9m due beyond that. Offsetting this, it had JP¥2.10b in cash and JP¥855.1m in receivables that were due within 12 months. So it can boast JP¥1.25b more liquid assets than total liabilities.

This short term liquidity is a sign that Fabrica Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Fabrica Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

But the bad news is that Fabrica Holdings has seen its EBIT plunge 17% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Fabrica Holdings'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Fabrica Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Fabrica Holdings's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Fabrica Holdings has JP¥1.82b in net cash and a decent-looking balance sheet. So we don't have any problem with Fabrica Holdings's use of debt. 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. We've identified 3 warning signs with Fabrica Holdings (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com