Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that China Sunshine Paper Holdings Company Limited (HKG:2002) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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.
How Much Debt Does China Sunshine Paper Holdings Carry?
The image below, which you can click on for greater detail, shows that China Sunshine Paper Holdings had debt of CN¥3.86b at the end of December 2020, a reduction from CN¥4.14b over a year. However, it does have CN¥627.0m in cash offsetting this, leading to net debt of about CN¥3.23b.
How Healthy Is China Sunshine Paper Holdings' Balance Sheet?
The latest balance sheet data shows that China Sunshine Paper Holdings had liabilities of CN¥5.19b due within a year, and liabilities of CN¥763.3m falling due after that. Offsetting this, it had CN¥627.0m in cash and CN¥857.1m in receivables that were due within 12 months. So its liabilities total CN¥4.46b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥1.06b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, China Sunshine Paper Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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).
China Sunshine Paper Holdings has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 6.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We note that China Sunshine Paper Holdings grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Sunshine Paper Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Sunshine Paper Holdings produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Mulling over China Sunshine Paper Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that China Sunshine Paper Holdings's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Be aware that China Sunshine Paper Holdings is showing 2 warning signs in our investment analysis , you should know about...
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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China Sunshine Paper Holdings
China Sunshine Paper Holdings Company Limited, together with its subsidiaries, produces and sells paper products in the People's Republic of China and internationally.
Slightly overvalued with imperfect balance sheet.