Does Meiko Electronics (TYO:6787) Have A Healthy Balance Sheet?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Meiko Electronics Co., Ltd. (TYO:6787) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Meiko Electronics

How Much Debt Does Meiko Electronics Carry?

The chart below, which you can click on for greater detail, shows that Meiko Electronics had JP¥68.7b in debt in December 2020; about the same as the year before. However, it does have JP¥13.9b in cash offsetting this, leading to net debt of about JP¥54.8b.

A Look At Meiko Electronics' Liabilities

We can see from the most recent balance sheet that Meiko Electronics had liabilities of JP¥58.3b falling due within a year, and liabilities of JP¥45.2b due beyond that. On the other hand, it had cash of JP¥13.9b and JP¥28.9b worth of receivables due within a year. So it has liabilities totalling JP¥60.7b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of JP¥70.1b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Meiko Electronics has net debt to EBITDA of 4.9 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.8 times its interest expense, and its net debt to EBITDA, was quite high, at 4.9. Importantly, Meiko Electronics's EBIT fell a jaw-dropping 22% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Meiko Electronics's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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 that EBIT is backed by free cash flow. Over the last three years, Meiko Electronics 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 Meiko Electronics's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think Meiko Electronics has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 1 warning sign for Meiko Electronics that you should be aware of before investing here.

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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