Is Kaori Heat Treatment (TPE:8996) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Kaori Heat Treatment Co., Ltd. (TPE:8996) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

See our latest analysis for Kaori Heat Treatment

How Much Debt Does Kaori Heat Treatment Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Kaori Heat Treatment had debt of NT$1.14b, up from NT$565.9m in one year. However, because it has a cash reserve of NT$628.6m, its net debt is less, at about NT$512.9m.

How Strong Is Kaori Heat Treatment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kaori Heat Treatment had liabilities of NT$997.4m due within 12 months and liabilities of NT$556.2m due beyond that. Offsetting these obligations, it had cash of NT$628.6m as well as receivables valued at NT$380.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$545.0m.

Since publicly traded Kaori Heat Treatment shares are worth a total of NT$5.06b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kaori Heat Treatment's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 31.7 times, makes us even more comfortable. The bad news is that Kaori Heat Treatment saw its EBIT decline by 17% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Kaori Heat Treatment 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Kaori Heat Treatment created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Kaori Heat Treatment's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Kaori Heat Treatment'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. 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. To that end, you should learn about the 4 warning signs we've spotted with Kaori Heat Treatment (including 3 which don't sit too well with us) .

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. 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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