Is Di-Nikko Engineering (TSE:6635) 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 Di-Nikko Engineering Co., Ltd. (TSE:6635) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Di-Nikko Engineering

What Is Di-Nikko Engineering's Debt?

The chart below, which you can click on for greater detail, shows that Di-Nikko Engineering had JP¥12.6b in debt in December 2023; about the same as the year before. On the flip side, it has JP¥3.52b in cash leading to net debt of about JP¥9.04b.

How Healthy Is Di-Nikko Engineering's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Di-Nikko Engineering had liabilities of JP¥17.1b due within 12 months and liabilities of JP¥5.18b due beyond that. Offsetting this, it had JP¥3.52b in cash and JP¥9.96b in receivables that were due within 12 months. So its liabilities total JP¥8.78b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the JP¥4.45b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Di-Nikko Engineering would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Di-Nikko Engineering has a rather high debt to EBITDA ratio of 7.5 which suggests a meaningful debt load. However, its interest coverage of 4.3 is reasonably strong, which is a good sign. Another concern for investors might be that Di-Nikko Engineering's EBIT fell 10% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Di-Nikko Engineering's earnings that will influence how the balance sheet holds up in the future. 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Di-Nikko Engineering saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Di-Nikko Engineering's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We think the chances that Di-Nikko Engineering has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Di-Nikko Engineering (of which 1 is potentially serious!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.