Here's Why Pacific Millennium Packaging Group (HKG:1820) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Pacific Millennium Packaging Group Corporation (HKG:1820) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Pacific Millennium Packaging Group

What Is Pacific Millennium Packaging Group's Net Debt?

As you can see below, Pacific Millennium Packaging Group had CN¥265.0m of debt at December 2020, down from CN¥320.0m a year prior. On the flip side, it has CN¥117.9m in cash leading to net debt of about CN¥147.1m.

How Strong Is Pacific Millennium Packaging Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Pacific Millennium Packaging Group had liabilities of CN¥680.8m due within 12 months and liabilities of CN¥158.7m due beyond that. On the other hand, it had cash of CN¥117.9m and CN¥564.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥156.9m.

Given Pacific Millennium Packaging Group has a market capitalization of CN¥1.51b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

While Pacific Millennium Packaging Group's low debt to EBITDA ratio of 0.76 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Sadly, Pacific Millennium Packaging Group's EBIT actually dropped 3.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Pacific Millennium Packaging Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Pacific Millennium Packaging Group produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On our analysis Pacific Millennium Packaging Group's net debt to EBITDA should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to grow its EBIT. When we consider all the elements mentioned above, it seems to us that Pacific Millennium Packaging Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Pacific Millennium Packaging Group that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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