Does China Lesso Group Holdings (HKG:2128) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 China Lesso Group Holdings Limited (HKG:2128) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that 2128 is potentially overvalued!

What Is China Lesso Group Holdings's Debt?

The image below, which you can click on for greater detail, shows that China Lesso Group Holdings had debt of CN¥17.0b at the end of June 2022, a reduction from CN¥18.9b over a year. However, it also had CN¥4.81b in cash, and so its net debt is CN¥12.2b.

How Healthy Is China Lesso Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Lesso Group Holdings had liabilities of CN¥18.3b due within 12 months and liabilities of CN¥13.1b due beyond that. Offsetting this, it had CN¥4.81b in cash and CN¥7.85b in receivables that were due within 12 months. So its liabilities total CN¥18.7b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥27.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

China Lesso Group Holdings has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 5.6 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, China Lesso Group Holdings's EBIT fell a jaw-dropping 55% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Lesso Group Holdings'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, China Lesso Group Holdings recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say China Lesso Group Holdings's EBIT growth rate was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. 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 everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 3 warning signs for China Lesso Group Holdings you should be aware of.

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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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.