Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies fonfun company (TTY: 2323) uses the debt. But does this debt worry shareholders?
What risk does debt entail?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
What is fonfun’s debt?
You can click on the graph below for the historical figures, but it shows that Fonfun had a debt of JPY 243.0 million as of December 2020, compared to JP 296.0 million a year earlier. However, he has JPY 525.0million in cash offsetting this, which leads to a net cash of JPY 282.0million.
Is the fund’s balance sheet healthy?
The latest balance sheet data shows that Fonfun had debts of JPY 181.0 million due within one year, and JP 159.0 million debts due thereafter. On the other hand, he had a cash position of JP 525.0 million and JP 96.0 million of receivables due within one year. So it actually has JP ¥ 281.0m Following liquid assets as total liabilities.
This surplus suggests that funfun is using the debt in a way that seems both safe and conservative. Due to its strong net asset position, it should not encounter any problems with its lenders. Put simply, the fact that a funfun has more cash than debt is probably a good indication that it can manage its debt safely.
Best of all, fonfun increased its EBIT by 311% last year, which is an impressive improvement. If sustained, this growth will make debt even more manageable in the years to come. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in isolation; since funfun will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. Although funfun has net cash on its balance sheet, it is always worth looking at its ability to convert earnings before interest and taxes (EBIT) into free cash flow, to help us understand how fast it is building (or erodes) that cash balance. . In the past three years, funfun has actually generated more free cash flow than EBIT. There is nothing better than cash flow to stay in the good graces of your lenders.
While it is always a good idea to investigate a company’s debt, in this case, fonfun has JPY 282.0 million in net cash and a decent balance sheet. The icing on the cake is that he converted 149% of that EBIT into free cash flow, earning JPY 100 million. We therefore do not believe that the use of debt by funfun is risky. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 2 warning signs for funfun which you should know before investing here.
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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