We Think Tokyo Lifestyle (NASDAQ:TKLF) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Tokyo Lifestyle Co., Ltd. (NASDAQ:TKLF) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tokyo Lifestyle

How Much Debt Does Tokyo Lifestyle Carry?

The chart below, which you can click on for greater detail, shows that Tokyo Lifestyle had US$66.6m in debt in September 2024; about the same as the year before. However, it does have US$3.08m in cash offsetting this, leading to net debt of about US$63.5m.

How Strong Is Tokyo Lifestyle's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tokyo Lifestyle had liabilities of US$107.6m due within 12 months and liabilities of US$11.9m due beyond that. Offsetting these obligations, it had cash of US$3.08m as well as receivables valued at US$107.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.94m.

This deficit is considerable relative to its market capitalization of US$14.8m, so it does suggest shareholders should keep an eye on Tokyo Lifestyle's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

With a net debt to EBITDA ratio of 6.5, it's fair to say Tokyo Lifestyle does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.0 times, suggesting it can responsibly service its obligations. We also note that Tokyo Lifestyle improved its EBIT from a last year's loss to a positive US$8.7m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tokyo Lifestyle's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Tokyo Lifestyle burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Tokyo Lifestyle's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its interest cover is not so bad. Looking at the bigger picture, it seems clear to us that Tokyo Lifestyle's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Tokyo Lifestyle (2 are concerning!) that you should be aware of before investing here.

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.