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External fund manager Li Lu, backed by Charlie Munger of Berkshire Hathaway, makes no secret of it when he says: “The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.” When we think about how risky a company is, we always like to look at its level of debt, as excessive debt can lead to ruin. It is important to Tokyo Corporation (TSE:9005) comes with debt, but the bigger question is: how much risk is associated with that debt?

When is debt dangerous?

Debt and other liabilities become risky for a company when it can’t easily meet those obligations, either through free cash flow or by raising capital at an attractive price. If the company can’t meet its legal obligations to repay the debt, shareholders could end up empty-handed. A more common (but still costly) situation, however, is when a company must dilute shareholders at a cheap share price just to get debt under control. However, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When considering how much debt a company has, you should first look at its cash and debt together.

Check out our latest analysis for Tokyo

How much is Tokyo’s net debt?

As you can see below, Tokyo had JP¥1.26 trillion in debt in March 2024, which is about the same as last year. You can click on the chart for more details. On the other hand, Tokyo has JP¥43.4 billion in cash, resulting in net debt of about JP¥1.21 trillion.

A look at Tokyo’s liabilities

According to the most recent balance sheet, Tokyu has liabilities of JP¥743.1 billion due within a year and liabilities of JP¥1.08 trillion due beyond that. These liabilities are offset by cash of JP¥43.4 billion and receivables of JP¥194.1 billion due within 12 months. So total liabilities JP¥1.59 trillion more than the combination of cash and short-term receivables.

Since this deficit is actually higher than the company’s market capitalization of JP¥1.06 trillion, we believe shareholders should keep an eye on Tokyu’s debt situation like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay off its debt through a capital increase at the current share price.

To quantify a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its interest expense (its interest cover). This way, we take into account both the absolute amount of debt and the interest rates paid on it.

Oddly enough, Tokyu has a sky-high EBITDA ratio of 6.7, indicating high debt, but a strong interest coverage of 14.1. This means that unless the company has access to very cheap credit, interest expenses are likely to rise in the future. Notably, Tokyu’s EBIT came in higher than Elon Musk’s, growing a whopping 113% year over year. The balance sheet is clearly the area to focus on when analyzing debt. But it’s future earnings, more than anything, that will determine Tokyu’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future, you can look at this free Report with analysts’ profit forecasts.

However, our final consideration is also important because a company can’t pay off debt with accounting profits; it needs cash. So it’s worth checking how much of that EBIT is covered by free cash flow. Over the past three years, Tokyu has burned through a lot of cash. While that may be a result of spending on growth, it does make debt far riskier.

Our view

Frankly, both Tokyu’s net debt to EBITDA and its track record of converting EBIT to free cash flow make us quite unhappy with its debt levels. But at least it does a pretty good job of covering its interest expense with its EBIT; that’s encouraging. Looking at the bigger picture, it seems clear to us that Tokyu’s debt is creating risks for the company. If all goes well, it can pay off, but the downside of that debt is a higher risk of permanent losses. There’s no doubt that we learn the most about debt from the balance sheet. But ultimately, every company can contain risks that exist off the balance sheet. These risks can be difficult to spot. Every company has them, and we’ve spotted them. 1 warning sign for Tokyo You should know about this.

Of course, if you’re one of those investors who prefers to buy stocks without the burden of debt, you should discover our exclusive list of net cash growth stocks today.

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This Simply Wall St article is of a general nature. We comment solely on 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.

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