The outside fund manager, backed by Charlie Munger of Berkshire Hathaway, Li Lu, makes no bones about it when he says, “The biggest investment risk is not price volatility, but whether you suffer a permanent capital loss.” It is only natural to consider a company’s balance sheet when examining how risky it is, as debt often occurs when a company collapses. Most importantly, Cosmos Initia Co., Ltd. TYO: 8844) does bear debts. But the most important question is: how much risk does that debt cause?
What risk does debt entail?
In general, debt only really becomes a problem if a company cannot pay it off easily, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal obligations to repay debt, shareholders can walk away with nothing. A more common (but still costly) event, however, is that a company has to issue shares at bargain prices, permanently diluting shareholders just to keep its balance sheet up. Of course, many companies use debt to finance growth without negative consequences. When we think about a company’s use of debt, let’s first look at cash and debt together.
How Much Debt Does Cosmos Initia Bear?
As you can see below, Cosmos Initia had JP ¥ 87.2 billion in debt in December 2020, down from JP ¥ 93.0ba a year earlier. On the other hand, it has JP ¥ 21.0 billion in cash, leading to net debt of approximately JP ¥ 66.2 billion.
How strong is Cosmos Initia’s balance sheet?
If we zoom in on the latest balance sheet data, we can see that Cosmos Initia had debt of JP ¥ 76.7 billion within 12 months and debt of JP ¥ 37.5 billion after that. To compensate for this, it had JP ¥ 21.0 billion in cash and JP ¥ 1.28 billion in receivables due within 12 months. Thus, his liabilities total JP ¥ 91.9 billion more than the combination of his cash and receivables.
This deficit casts a shadow over JP ¥ 14.6b, a colossus towering over mere mortals. So we absolutely think shareholders should keep a close eye on this. After all, Cosmos Initia would likely require a major recapitalization if it had to pay its creditors today.
We use two main ratios to inform ourselves about the level of debt to earnings. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how many times earnings before interest and taxes (EBIT) cover the interest expense (or interest coverage for short). . The advantage of this approach is that we take into account both the absolute debt amount (with net debt to EBITDA) and the actual interest expense associated with that debt (with the interest coverage ratio).
Cosmos Initia has a reasonable net debt / EBITDA ratio of 30.3 but a very strong interest coverage of 29.5. So it has access to very cheap long-term debt or that interest expense will increase! Importantly, Cosmos Initia’s EBIT has declined by 62% in the past twelve months. If that income trend continues, paying off the debt will be about as easy as herding cats on a rollercoaster. When analyzing debt levels, balance sheet is the obvious place to start. But it is Cosmos Initia’s earnings that will affect how the balance sheet holds up going forward. So if you are considering debt, it is definitely worth looking at the earnings development. Click here for an interactive snapshot
But our final consideration is also important, because a company cannot pay off debt with paper profits; it needs cold hard cash. So the logical step is to look at the part of that EBIT that corresponds to the actual free cash flow. In the past three years, Cosmos Initia has burned a lot of money. That may be the result of spending on growth, but it makes debt much more risky.
On the face of it, Cosmos Initia’s EBIT growth rate left us hesitant about inventory, and the level of total liabilities was no more enticing than the only empty restaurant on the busiest night of the year. But on the other hand, interest coverage is a good sign and makes us more optimistic. We think the chances of Cosmos Initia being over-indebted are very high. For us, that makes the stock quite risky, like walking through a dog park with your eyes closed. But some investors will think otherwise. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks are in the balance sheet – far from it. Example: we have seen it 3 warning signs for Cosmos Initia you should be aware of them, and 2 of them should not be ignored.
After all that, if you’re more interested in a fast-growing company with a rock-solid balance sheet, check it out our list of net cash growth stocks without delay.
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This article from Simply Wall St is general in nature. It is not a recommendation to buy or sell stock and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis driven by fundamental data. Note that our analysis may not take into account the latest price sensitive company announcements or quality material. Simply Wall St has no exposure to said stocks.
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