Here's Why Takamisawa Cybernetics Company (TYO:6424) Can Manage Its Debt Responsibly

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. Importantly, Takamisawa Cybernetics Company, Ltd. (TYO:6424) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Takamisawa Cybernetics Company

How Much Debt Does Takamisawa Cybernetics Company Carry?

As you can see below, Takamisawa Cybernetics Company had JP¥2.88b of debt at September 2020, down from JP¥3.95b a year prior. On the flip side, it has JP¥1.84b in cash leading to net debt of about JP¥1.04b.

How Strong Is Takamisawa Cybernetics Company's Balance Sheet?

The latest balance sheet data shows that Takamisawa Cybernetics Company had liabilities of JP¥7.12b due within a year, and liabilities of JP¥3.38b falling due after that. On the other hand, it had cash of JP¥1.84b and JP¥2.75b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥5.90b.

Given this deficit is actually higher than the company's market capitalization of JP¥4.02b, we think shareholders really should watch Takamisawa Cybernetics Company's debt levels, like a parent watching their child ride a bike for the first time. 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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 0.85 times its EBITDA. And its EBIT easily covers its interest expense, being 13.9 times the size. So we're pretty relaxed about its super-conservative use of debt. Better yet, Takamisawa Cybernetics Company grew its EBIT by 345% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Takamisawa Cybernetics Company 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Takamisawa Cybernetics Company recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Both Takamisawa Cybernetics Company's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. Considering this range of data points, we think Takamisawa Cybernetics Company is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Takamisawa Cybernetics Company (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

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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