Is Sakae Electronics (TYO:7567) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Sakae Electronics Corporation (TYO:7567) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sakae Electronics

What Is Sakae Electronics's Net Debt?

As you can see below, Sakae Electronics had JP¥737.0m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. But it also has JP¥1.21b in cash to offset that, meaning it has JP¥471.0m net cash.

A Look At Sakae Electronics' Liabilities

We can see from the most recent balance sheet that Sakae Electronics had liabilities of JP¥2.18b falling due within a year, and liabilities of JP¥167.0m due beyond that. On the other hand, it had cash of JP¥1.21b and JP¥1.56b worth of receivables due within a year. So it actually has JP¥414.0m more liquid assets than total liabilities.

This surplus suggests that Sakae Electronics is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Sakae Electronics boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that Sakae Electronics has boosted its EBIT by 48%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sakae Electronics's earnings that will influence how the balance sheet holds up in the future. 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. Sakae Electronics may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Sakae Electronics actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While it is always sensible to investigate a company's debt, in this case Sakae Electronics has JP¥471.0m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 170% of that EBIT to free cash flow, bringing in JP¥247m. When it comes to Sakae Electronics's debt, we sufficiently relaxed that our mind turns to the jacuzzi. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Sakae Electronics is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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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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