We Think China Lesso Group Holdings (HKG:2128) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies China Lesso Group Holdings Limited (HKG:2128) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

View our latest analysis for China Lesso Group Holdings

What Is China Lesso Group Holdings's Net Debt?

As you can see below, China Lesso Group Holdings had CN¥17.0b of debt at June 2022, down from CN¥18.9b a year prior. However, it does have CN¥6.28b in cash offsetting this, leading to net debt of about CN¥10.7b.

A Look At China Lesso Group Holdings' Liabilities

According to the last reported balance sheet, China Lesso Group Holdings had liabilities of CN¥18.3b due within 12 months, and liabilities of CN¥13.1b due beyond 12 months. On the other hand, it had cash of CN¥6.28b and CN¥6.63b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.5b.

This is a mountain of leverage relative to its market capitalization of CN¥25.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Lesso Group Holdings has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 5.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, China Lesso Group Holdings's EBIT fell a jaw-dropping 55% 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 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'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 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 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say China Lesso Group Holdings's EBIT growth rate was disappointing. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that China Lesso Group 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for China Lesso Group Holdings that you should be aware of.

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.