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. As with many other companies Lee & Man Chemical Company Limited (HKG:746) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Lee & Man Chemical Carry?
As you can see below, Lee & Man Chemical had HK$1.86b of debt at June 2019, down from HK$2.06b a year prior. On the flip side, it has HK$591.2m in cash leading to net debt of about HK$1.27b.
How Healthy Is Lee & Man Chemical's Balance Sheet?
The latest balance sheet data shows that Lee & Man Chemical had liabilities of HK$1.55b due within a year, and liabilities of HK$889.1m falling due after that. Offsetting these obligations, it had cash of HK$591.2m as well as receivables valued at HK$297.2m due within 12 months. So it has liabilities totalling HK$1.55b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Lee & Man Chemical has a market capitalization of HK$3.25b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Lee & Man Chemical's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its commanding EBIT of 11.5 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Lee & Man Chemical's EBIT fell a jaw-dropping 22% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Lee & Man Chemical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Lee & Man Chemical's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Lee & Man Chemical's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its interest cover was re-invigorating. When we consider all the factors discussed, it seems to us that Lee & Man Chemical is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given Lee & Man Chemical 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.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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