Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. 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.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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.
What Is China Lesso Group Holdings's Debt?
As you can see below, at the end of December 2021, China Lesso Group Holdings had CN¥17.8b of debt, up from CN¥16.1b a year ago. Click the image for more detail. On the flip side, it has CN¥8.47b in cash leading to net debt of about CN¥9.36b.
How Healthy Is China Lesso Group Holdings' Balance Sheet?
We can see from the most recent balance sheet that China Lesso Group Holdings had liabilities of CN¥20.9b falling due within a year, and liabilities of CN¥11.8b due beyond that. Offsetting this, it had CN¥8.47b in cash and CN¥5.94b in receivables that were due within 12 months. So it has liabilities totalling CN¥18.3b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CN¥21.3b, so it does suggest shareholders should keep an eye on China Lesso Group Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
China Lesso Group Holdings has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 7.0 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Shareholders should be aware that China Lesso Group Holdings's EBIT was down 36% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, China Lesso Group Holdings's free cash flow amounted to 35% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Mulling over China Lesso Group Holdings's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that China Lesso Group Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for China Lesso Group Holdings (of which 1 is a bit unpleasant!) you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.