We Think Tobu Railway (TSE:9001) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Tobu Railway Co., Ltd. (TSE:9001) does use debt in its business. But the real question is whether this debt is making the company risky.

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Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Tobu Railway's Net Debt?

As you can see below, at the end of December 2024, Tobu Railway had JP¥794.4b of debt, up from JP¥753.9b a year ago. Click the image for more detail. However, it also had JP¥45.8b in cash, and so its net debt is JP¥748.6b.

A Look At Tobu Railway's Liabilities

We can see from the most recent balance sheet that Tobu Railway had liabilities of JP¥455.8b falling due within a year, and liabilities of JP¥744.5b due beyond that. Offsetting these obligations, it had cash of JP¥45.8b as well as receivables valued at JP¥72.6b due within 12 months. So its liabilities total JP¥1.08t more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the JP¥512.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Tobu Railway would likely require a major re-capitalisation if it had to pay its creditors today.

Check out our latest analysis for Tobu Railway

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 Tobu Railway has a sky high EBITDA ratio of 5.9, implying high debt, but a strong interest coverage of 25.3. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly Tobu Railway's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Tobu Railway can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Tobu Railway's free cash flow amounted to 35% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Tobu Railway's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Tobu Railway to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Tobu Railway is showing 3 warning signs in our investment analysis , and 2 of those are concerning...

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.