Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Lee & Man Paper Manufacturing Limited (HKG:2314) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Lee & Man Paper Manufacturing's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2023 Lee & Man Paper Manufacturing had HK$19.3b of debt, an increase on HK$16.3b, over one year. However, it also had HK$1.52b in cash, and so its net debt is HK$17.8b.
How Healthy Is Lee & Man Paper Manufacturing's Balance Sheet?
We can see from the most recent balance sheet that Lee & Man Paper Manufacturing had liabilities of HK$11.4b falling due within a year, and liabilities of HK$13.9b due beyond that. Offsetting this, it had HK$1.52b in cash and HK$6.70b in receivables that were due within 12 months. So it has liabilities totalling HK$17.1b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the HK$10.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Lee & Man Paper Manufacturing would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a net debt to EBITDA ratio of 19.4, it's fair to say Lee & Man Paper Manufacturing does have a significant amount of debt. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. However, one redeeming factor is that Lee & Man Paper Manufacturing grew its EBIT at 14% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lee & Man Paper Manufacturing's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Lee & Man Paper Manufacturing burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
To be frank both Lee & Man Paper Manufacturing's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Taking into account all the aforementioned factors, it looks like Lee & Man Paper Manufacturing has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Lee & Man Paper Manufacturing that you should be aware of before investing here.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.