Does Kaori Heat Treatment (TWSE:8996) Have A Healthy Balance Sheet?

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 note that Kaori Heat Treatment Co., Ltd. (TWSE:8996) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Kaori Heat Treatment

What Is Kaori Heat Treatment's Net Debt?

As you can see below, Kaori Heat Treatment had NT$927.6m of debt at September 2024, down from NT$1.88b a year prior. On the flip side, it has NT$777.0m in cash leading to net debt of about NT$150.6m.

A Look At Kaori Heat Treatment's Liabilities

Zooming in on the latest balance sheet data, we can see that Kaori Heat Treatment had liabilities of NT$1.01b due within 12 months and liabilities of NT$830.3m due beyond that. Offsetting these obligations, it had cash of NT$777.0m as well as receivables valued at NT$1.11b due within 12 months. So it actually has NT$45.7m more liquid assets than total liabilities.

Having regard to Kaori Heat Treatment's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the NT$24.7b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Kaori Heat Treatment has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Kaori Heat Treatment's net debt is only 0.19 times its EBITDA. And its EBIT easily covers its interest expense, being 35.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Kaori Heat Treatment's EBIT dived 17%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Kaori Heat Treatment's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Kaori Heat Treatment's free cash flow amounted to 30% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Kaori Heat Treatment's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Considering this range of data points, we think Kaori Heat Treatment is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example - Kaori Heat Treatment has 1 warning sign we think you should be aware of.

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.