We Think Kyogoku unyu shoji (TYO:9073) Is Taking Some Risk With Its 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.' 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. We can see that Kyogoku unyu shoji Co., Ltd (TYO:9073) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Kyogoku unyu shoji

How Much Debt Does Kyogoku unyu shoji Carry?

The chart below, which you can click on for greater detail, shows that Kyogoku unyu shoji had JP¥1.43b in debt in September 2020; about the same as the year before. On the flip side, it has JP¥1.07b in cash leading to net debt of about JP¥362.0m.

How Strong Is Kyogoku unyu shoji's Balance Sheet?

According to the last reported balance sheet, Kyogoku unyu shoji had liabilities of JP¥2.30b due within 12 months, and liabilities of JP¥1.68b due beyond 12 months. Offsetting these obligations, it had cash of JP¥1.07b as well as receivables valued at JP¥1.16b due within 12 months. So its liabilities total JP¥1.75b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of JP¥1.73b, we think shareholders really should watch Kyogoku unyu shoji's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Kyogoku unyu shoji has a low debt to EBITDA ratio of only 0.76. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. The modesty of its debt load may become crucial for Kyogoku unyu shoji if management cannot prevent a repeat of the 54% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kyogoku unyu shoji 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Kyogoku unyu shoji actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

While Kyogoku unyu shoji's EBIT growth rate has us nervous. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. We think that Kyogoku unyu shoji's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Take risks, for example - Kyogoku unyu shoji has 4 warning signs (and 1 which can't be ignored) we think 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. 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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