Shikoku Electric Power Company (TSE:9507) Takes On Some Risk With Its Use Of 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. Importantly, Shikoku Electric Power Company, Incorporated (TSE:9507) does carry debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shikoku Electric Power Company

What Is Shikoku Electric Power Company's Net Debt?

The chart below, which you can click on for greater detail, shows that Shikoku Electric Power Company had JP¥918.2b in debt in September 2024; about the same as the year before. However, it also had JP¥108.9b in cash, and so its net debt is JP¥809.3b.

A Look At Shikoku Electric Power Company's Liabilities

According to the last reported balance sheet, Shikoku Electric Power Company had liabilities of JP¥257.1b due within 12 months, and liabilities of JP¥985.5b due beyond 12 months. Offsetting these obligations, it had cash of JP¥108.9b as well as receivables valued at JP¥122.9b due within 12 months. So it has liabilities totalling JP¥1.01t more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥242.3b 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. At the end of the day, Shikoku Electric Power Company would probably need a major re-capitalization if its creditors were to demand repayment.

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).

As it happens Shikoku Electric Power Company has a fairly concerning net debt to EBITDA ratio of 6.0 but very strong interest coverage of 16.8. 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 Shikoku Electric Power Company's EBIT shot up like bamboo after rain, gaining 56% 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 ultimately the future profitability of the business will decide if Shikoku Electric Power Company can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept 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 two years, Shikoku Electric Power Company's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Shikoku Electric Power Company's level of total liabilities has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We should also note that Electric Utilities industry companies like Shikoku Electric Power Company commonly do use debt without problems. 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. 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. For example, we've discovered 4 warning signs for Shikoku Electric Power Company (2 can't be ignored!) that you should be aware of before investing here.

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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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.