Is Tomen Devices (TSE:2737) Using Too Much Debt?

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. Importantly, Tomen Devices Corporation (TSE:2737) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Tomen Devices

What Is Tomen Devices's Net Debt?

The image below, which you can click on for greater detail, shows that Tomen Devices had debt of JP¥28.6b at the end of December 2023, a reduction from JP¥47.0b over a year. However, because it has a cash reserve of JP¥13.8b, its net debt is less, at about JP¥14.8b.

How Healthy Is Tomen Devices' Balance Sheet?

The latest balance sheet data shows that Tomen Devices had liabilities of JP¥72.6b due within a year, and liabilities of JP¥691.0m falling due after that. Offsetting these obligations, it had cash of JP¥13.8b as well as receivables valued at JP¥52.5b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥6.95b.

Of course, Tomen Devices has a market capitalization of JP¥43.1b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Tomen Devices has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.8 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Shareholders should be aware that Tomen Devices's EBIT was down 31% last year. 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 you can't view debt in total isolation; since Tomen Devices 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Tomen Devices generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Based on what we've seen Tomen Devices is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Tomen Devices's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more 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. Be aware that Tomen Devices is showing 3 warning signs in our investment analysis , you should know about...

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.