Is Takase (TYO:9087) 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.' 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. As with many other companies Takase Corporation (TYO:9087) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Takase

What Is Takase's Net Debt?

As you can see below, Takase had JP¥2.63b of debt at December 2020, down from JP¥3.01b a year prior. However, it does have JP¥2.15b in cash offsetting this, leading to net debt of about JP¥476.0m.

How Healthy Is Takase's Balance Sheet?

According to the last reported balance sheet, Takase had liabilities of JP¥1.66b due within 12 months, and liabilities of JP¥2.23b due beyond 12 months. On the other hand, it had cash of JP¥2.15b and JP¥942.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥799.0m.

While this might seem like a lot, it is not so bad since Takase has a market capitalization of JP¥2.04b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

While Takase's low debt to EBITDA ratio of 0.98 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. On the other hand, Takase saw its EBIT drop by 6.6% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Takase'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Takase recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Takase's conversion of EBIT to free cash flow does give us pause, its net debt to EBITDA and interest cover suggest it can stay on top of its debt load. We think that Takase'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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Takase you should be aware of, and 1 of them is potentially serious.

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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