Some say that volatility, not debt, is the best way to think about risk as an investor, but Warren Buffett once said, “Volatility is far from synonymous with risk.” When we think about how risky a company is, we always like to look at its level of debt, since excessive debt can lead to ruin. We find that Sankyu Inc. (TSE:9065) has debt on its balance sheet. But is this debt a cause for concern for shareholders?

Why is debt risky?

Debt and other liabilities become risky for a company when it cannot easily meet those obligations, either through free cash flow or by raising capital at an attractive price. A key part of capitalism is the process of “creative destruction,” in which failed companies are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that the company must raise new equity at a low price, permanently diluting shareholders’ interest. The advantage of debt, of course, is that it often represents cheap capital, especially when it replaces a company’s dilution with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first consider cash and debt together.

Check out our latest analysis for Sankyu

How much debt does Sankyu have?

The image below, which you can click on for more details, shows that Sankyu had JP¥94.5 billion in debt as of June 2024, up from JP¥78.3 billion a year earlier. However, the company also had JP¥50.9 billion in cash, so its net debt is JP¥43.7 billion.

A look at Sankyu’s liabilities

From the most recent balance sheet, we can see that Sankyu had liabilities of JP¥122.3 billion due within a year and accounts payable of JP¥108.7 billion due beyond that. On the other hand, the company had cash of JP¥50.9 billion and accounts receivable of JP¥200.4 billion due within a year. So, the company actually has JP¥20.2 billion more Liquid assets are greater than total liabilities.

This surplus suggests that Sankyu has a conservative balance sheet and could probably reduce its debt without major difficulties.

We use two main ratios to inform us about the level of debt relative to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second tells us how much earnings before interest and taxes (EBIT) covers interest expenses (or interest cover for short). This way, we take into account both the absolute amount of debt and the interest rates paid on it.

Sankyu has a low debt-to-EBITDA ratio of just 0.79. And remarkably, despite having net debt, the company actually received more interest than it paid over the last twelve months. So there’s no doubt that this company can take on debt and remain quite calm about it. However, the other side of the story is that Sankyu saw its EBIT decline by 7.6% over the last year. Such a decline, if sustained, will obviously make debt more difficult to manage. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will determine whether Sankyu can strengthen its balance sheet over time. So if you want to know what the professionals think, you might find this free report on analyst profit forecasts interesting.

Finally, while the taxman loves retained earnings, lenders only accept cold hard cash. That’s why we always check how much of that EBIT is converted into free cash flow. Looking at the last three years, Sankyu recorded free cash flow of 44% of its EBIT, which is weaker than expected. This weak cash conversion makes it difficult to manage debt.

Our view

The good news is that Sankyu’s proven ability to cover its interest expenses with its EBIT makes us as happy as a fluffy puppy does a toddler. But to be honest, we think its EBIT growth rate undermines that impression a little. Taking all of these things into account, it seems that Sankyu can easily handle its current debt. Of course, this debt can boost return on equity, but it also brings more risk, so it’s worth keeping an eye on. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks are contained in the balance sheet – quite the opposite. For example, Sankyu has 1 warning sign In our opinion, you should be aware of this.

If you are interested in investing in companies that can grow profits without the burden of debt, check this out free List of growing companies that have net cash on their balance sheet.

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This Simply Wall St article is of a general nature. We comment solely on the basis of historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.