Is Nagoya Railroad (TSE:9048) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Nagoya Railroad Co., Ltd. (TSE:9048) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Nagoya Railroad

How Much Debt Does Nagoya Railroad Carry?

As you can see below, at the end of March 2024, Nagoya Railroad had JP¥488.2b of debt, up from JP¥463.9b a year ago. Click the image for more detail. On the flip side, it has JP¥60.4b in cash leading to net debt of about JP¥427.8b.

How Healthy Is Nagoya Railroad's Balance Sheet?

We can see from the most recent balance sheet that Nagoya Railroad had liabilities of JP¥308.9b falling due within a year, and liabilities of JP¥530.7b due beyond that. Offsetting these obligations, it had cash of JP¥60.4b as well as receivables valued at JP¥65.5b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥713.8b.

This deficit casts a shadow over the JP¥335.6b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Nagoya Railroad 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). 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).

As it happens Nagoya Railroad has a fairly concerning net debt to EBITDA ratio of 5.8 but very strong interest coverage of 21.3. 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 Nagoya Railroad's EBIT shot up like bamboo after rain, gaining 53% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Nagoya Railroad's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Nagoya Railroad burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Nagoya Railroad'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. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Nagoya Railroad's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 Nagoya Railroad is showing 1 warning sign in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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