Is Di-Nikko Engineering (TYO:6635) A Risky Investment?

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.' 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 note that Di-Nikko Engineering Co., Ltd. (TYO:6635) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Di-Nikko Engineering

What Is Di-Nikko Engineering's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Di-Nikko Engineering had JP¥10.6b of debt, an increase on JP¥10.1b, over one year. However, it does have JP¥1.83b in cash offsetting this, leading to net debt of about JP¥8.74b.

How Healthy Is Di-Nikko Engineering's Balance Sheet?

According to the last reported balance sheet, Di-Nikko Engineering had liabilities of JP¥10.7b due within 12 months, and liabilities of JP¥6.11b due beyond 12 months. Offsetting these obligations, it had cash of JP¥1.83b as well as receivables valued at JP¥6.80b due within 12 months. So its liabilities total JP¥8.16b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the JP¥2.97b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Di-Nikko Engineering would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Di-Nikko Engineering shareholders face the double whammy of a high net debt to EBITDA ratio (19.9), and fairly weak interest coverage, since EBIT is just 1.7 times the interest expense. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Di-Nikko Engineering actually grew its EBIT by a hefty 407%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Di-Nikko Engineering 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Di-Nikko Engineering saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Di-Nikko Engineering's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Di-Nikko Engineering's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 5 warning signs for Di-Nikko Engineering (1 is concerning!) 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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