Is China Lesso Group Holdings (HKG:2128) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China Lesso Group Holdings Limited (HKG:2128) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Lesso Group Holdings

What Is China Lesso Group Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 China Lesso Group Holdings had CN¥20.0b of debt, an increase on CN¥17.8b, over one year. However, because it has a cash reserve of CN¥6.65b, its net debt is less, at about CN¥13.4b.

How Healthy Is China Lesso Group Holdings' Balance Sheet?

According to the last reported balance sheet, China Lesso Group Holdings had liabilities of CN¥21.4b due within 12 months, and liabilities of CN¥14.9b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.65b as well as receivables valued at CN¥7.55b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥22.2b.

When you consider that this deficiency exceeds the company's CN¥15.4b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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). 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).

China Lesso Group Holdings has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.1 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. One way China Lesso Group Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, China Lesso Group Holdings recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say China Lesso Group Holdings's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Lesso Group Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for China Lesso Group Holdings that you should be aware of before investing here.

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.