River Eletec (TYO:6666) Has A Pretty 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.' 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. As with many other companies River Eletec Corporation (TYO:6666) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, 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.

See our latest analysis for River Eletec

What Is River Eletec's Net Debt?

You can click the graphic below for the historical numbers, but it shows that River Eletec had JP¥4.49b of debt in September 2020, down from JP¥4.68b, one year before. However, it also had JP¥1.76b in cash, and so its net debt is JP¥2.73b.

How Strong Is River Eletec's Balance Sheet?

The latest balance sheet data shows that River Eletec had liabilities of JP¥3.46b due within a year, and liabilities of JP¥2.49b falling due after that. Offsetting this, it had JP¥1.76b in cash and JP¥1.15b in receivables that were due within 12 months. So it has liabilities totalling JP¥3.03b more than its cash and near-term receivables, combined.

This deficit isn't so bad because River Eletec is worth JP¥11.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 3.9 River Eletec has a fairly noticeable amount of debt. But the high interest coverage of 7.3 suggests it can easily service that debt. We also note that River Eletec improved its EBIT from a last year's loss to a positive JP¥314m. When analysing debt levels, the balance sheet is the obvious place to start. But it is River Eletec's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, River Eletec actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On our analysis River Eletec's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that River Eletec is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 instance, we've identified 2 warning signs for River Eletec (1 is significant) you should be aware of.

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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