Does Takamisawa Cybernetics Company (TYO:6424) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Takamisawa Cybernetics Company, Ltd. (TYO:6424) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Takamisawa Cybernetics Company

What Is Takamisawa Cybernetics Company's Debt?

As you can see below, Takamisawa Cybernetics Company had JP¥3.81b of debt at December 2020, down from JP¥4.64b a year prior. However, it does have JP¥2.16b in cash offsetting this, leading to net debt of about JP¥1.65b.

How Strong Is Takamisawa Cybernetics Company's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Takamisawa Cybernetics Company had liabilities of JP¥7.75b due within 12 months and liabilities of JP¥3.47b due beyond that. Offsetting these obligations, it had cash of JP¥2.16b as well as receivables valued at JP¥3.17b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥5.88b.

When you consider that this deficiency exceeds the company's JP¥4.37b 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). 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).

Takamisawa Cybernetics Company's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 16.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Takamisawa Cybernetics Company has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Takamisawa Cybernetics Company will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Takamisawa Cybernetics Company recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Takamisawa Cybernetics Company's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Takamisawa Cybernetics Company is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Takamisawa Cybernetics Company (at least 1 which is concerning) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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