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, Nine Dragons Paper (Holdings) Limited (HKG:2689) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Nine Dragons Paper (Holdings) Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Nine Dragons Paper (Holdings) had debt of CN¥32.9b, up from CN¥29.3b in one year. On the flip side, it has CN¥9.76b in cash leading to net debt of about CN¥23.2b.
How Strong Is Nine Dragons Paper (Holdings)'s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Nine Dragons Paper (Holdings) had liabilities of CN¥24.2b due within 12 months and liabilities of CN¥21.0b due beyond that. Offsetting these obligations, it had cash of CN¥9.76b as well as receivables valued at CN¥7.29b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥28.1b.
When you consider that this deficiency exceeds the company's CN¥26.4b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
We'd say that Nine Dragons Paper (Holdings)'s moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its commanding EBIT of 10.5 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Nine Dragons Paper (Holdings)'s EBIT flopped 16% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Nine Dragons Paper (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 company can only pay off debt with cold hard cash, not accounting profits. 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, Nine Dragons Paper (Holdings)'s free cash flow amounted to 24% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Nine Dragons Paper (Holdings)'s level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Nine Dragons Paper (Holdings)'s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Given Nine Dragons Paper (Holdings) 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.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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