MINATO HOLDINGS (TYO:6862) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 MINATO HOLDINGS INC. (TYO:6862) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for MINATO HOLDINGS

How Much Debt Does MINATO HOLDINGS Carry?

As you can see below, at the end of September 2020, MINATO HOLDINGS had JP¥6.04b of debt, up from JP¥4.43b a year ago. Click the image for more detail. However, it also had JP¥2.33b in cash, and so its net debt is JP¥3.71b.

A Look At MINATO HOLDINGS' Liabilities

According to the last reported balance sheet, MINATO HOLDINGS had liabilities of JP¥7.30b due within 12 months, and liabilities of JP¥1.72b due beyond 12 months. Offsetting these obligations, it had cash of JP¥2.33b as well as receivables valued at JP¥3.07b due within 12 months. So it has liabilities totalling JP¥3.63b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's JP¥3.47b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

MINATO HOLDINGS's net debt to EBITDA ratio is 10.8 which suggests rather high debt levels, but its interest cover of 9.5 times suggests the debt is easily serviced. Our best guess is that the company does indeed have significant debt obligations. Importantly, MINATO HOLDINGS's EBIT fell a jaw-dropping 33% 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since MINATO HOLDINGS 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 last three years, MINATO HOLDINGS actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On the face of it, MINATO HOLDINGS's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making MINATO HOLDINGS stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for MINATO HOLDINGS (1 is a bit unpleasant) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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