Is Shikoku Electric Power Company (TSE:9507) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Shikoku Electric Power Company, Incorporated (TSE:9507) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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, 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.

See our latest analysis for Shikoku Electric Power Company

What Is Shikoku Electric Power Company's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shikoku Electric Power Company had JP¥842.0b of debt in March 2024, down from JP¥948.3b, one year before. On the flip side, it has JP¥118.3b in cash leading to net debt of about JP¥723.6b.

How Strong Is Shikoku Electric Power Company's Balance Sheet?

According to the last reported balance sheet, Shikoku Electric Power Company had liabilities of JP¥231.3b due within 12 months, and liabilities of JP¥1.03t due beyond 12 months. Offsetting this, it had JP¥118.3b in cash and JP¥108.3b in receivables that were due within 12 months. So it has liabilities totalling JP¥1.04t more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥293.3b 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, Shikoku Electric Power Company would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shikoku Electric Power Company has a debt to EBITDA ratio of 4.9, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 18.7 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Notably, Shikoku Electric Power Company made a loss at the EBIT level, last year, but improved that to positive EBIT of JP¥79b in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shikoku Electric Power Company 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Shikoku Electric Power Company generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

While Shikoku Electric Power Company's level of total liabilities has us nervous. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. It's also worth noting that Shikoku Electric Power Company is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Shikoku Electric Power Company's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Shikoku Electric Power Company is showing 3 warning signs in our investment analysis , and 2 of those are concerning...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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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