Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Senkon Logistics Co., Ltd. (TYO:9051) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Senkon Logistics's Net Debt?
As you can see below, Senkon Logistics had JP¥9.69b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had JP¥3.28b in cash, and so its net debt is JP¥6.41b.
How Strong Is Senkon Logistics' Balance Sheet?
The latest balance sheet data shows that Senkon Logistics had liabilities of JP¥6.71b due within a year, and liabilities of JP¥7.41b falling due after that. On the other hand, it had cash of JP¥3.28b and JP¥1.63b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥9.20b.
This deficit casts a shadow over the JP¥4.13b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Senkon Logistics would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Strangely Senkon Logistics has a sky high EBITDA ratio of 5.2, implying high debt, but a strong interest coverage of 12.4. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that Senkon Logistics's EBIT shot up like bamboo after rain, gaining 70% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Senkon Logistics'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Senkon Logistics actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Senkon Logistics's level of total liabilities was a real negative on this analysis, as was its net debt to EBITDA. But like a ballerina ending on a perfect pirouette, it has not trouble covering its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Senkon Logistics's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Senkon Logistics is showing 3 warning signs in our investment analysis , and 1 of those is significant...
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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