Solekia (TYO:9867) Seems To Use Debt Rather Sparingly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Solekia Limited (TYO:9867) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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 Solekia

How Much Debt Does Solekia Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Solekia had debt of JP¥2.11b, up from JP¥1.11b in one year. However, its balance sheet shows it holds JP¥6.38b in cash, so it actually has JP¥4.27b net cash.

A Look At Solekia's Liabilities

Zooming in on the latest balance sheet data, we can see that Solekia had liabilities of JP¥5.55b due within 12 months and liabilities of JP¥2.08b due beyond that. On the other hand, it had cash of JP¥6.38b and JP¥4.25b worth of receivables due within a year. So it actually has JP¥3.00b more liquid assets than total liabilities.

This surplus strongly suggests that Solekia has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Succinctly put, Solekia boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Solekia if management cannot prevent a repeat of the 39% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Solekia 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Solekia 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. During the last three years, Solekia generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Solekia has JP¥4.27b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of JP¥727m, being 84% of its EBIT. So we don't think Solekia's use of debt is risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Solekia you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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