The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that China Lesso Group Holdings Limited (HKG:2128) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for China Lesso Group Holdings
How Much Debt Does China Lesso Group Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2023 China Lesso Group Holdings had debt of CN¥22.8b, up from CN¥17.0b in one year. However, it does have CN¥5.64b in cash offsetting this, leading to net debt of about CN¥17.1b.
SEHK:2128 Debt to Equity History October 9th 2023
How Healthy Is China Lesso Group Holdings' Balance Sheet?
According to the last reported balance sheet, China Lesso Group Holdings had liabilities of CN¥21.1b due within 12 months, and liabilities of CN¥17.3b due beyond 12 months. Offsetting these obligations, it had cash of CN¥5.64b as well as receivables valued at CN¥7.63b due within 12 months. So it has liabilities totalling CN¥25.1b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥11.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, China Lesso Group Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
China Lesso Group Holdings has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 5.3 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that China Lesso Group Holdings's EBIT shot up like bamboo after rain, gaining 57% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Lesso Group Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, China Lesso Group Holdings's free cash flow amounted to 30% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.