David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Lee and Man Paper Manufacturing Limited (HKG:2314) does carry debt. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Lee and Man Paper Manufacturing Carry?
As you can see below, Lee and Man Paper Manufacturing had HK$13.8b of debt at December 2018, down from HK$15.1b a year prior. However, because it has a cash reserve of HK$2.01b, its net debt is less, at about HK$11.8b.
How Healthy Is Lee and Man Paper Manufacturing's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Lee and Man Paper Manufacturing had liabilities of HK$10.2b due within 12 months and liabilities of HK$9.41b due beyond that. On the other hand, it had cash of HK$2.01b and HK$5.61b worth of receivables due within a year. So its liabilities total HK$12.0b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of HK$18.5b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We'd say that Lee and Man Paper Manufacturing's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its strong interest cover of 17.9 times, makes us even more comfortable. Sadly, Lee and Man Paper Manufacturing's EBIT actually dropped 7.7% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Lee and Man Paper Manufacturing's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Lee and Man Paper Manufacturing recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Lee and Man Paper Manufacturing's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Lee and Man Paper Manufacturing's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given Lee and Man Paper Manufacturing has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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