Here's Why Lee and Man Paper Manufacturing (HKG:2314) Can Manage Its Debt Responsibly

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 Lee and Man Paper Manufacturing Limited (HKG:2314) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Lee and Man Paper Manufacturing

How Much Debt Does Lee and Man Paper Manufacturing Carry?

You can click the graphic below for the historical numbers, but it shows that Lee and Man Paper Manufacturing had HK$11.3b of debt in December 2020, down from HK$12.3b, one year before. However, because it has a cash reserve of HK$1.18b, its net debt is less, at about HK$10.1b.

A Look At Lee and Man Paper Manufacturing's Liabilities

Zooming in on the latest balance sheet data, we can see that Lee and Man Paper Manufacturing had liabilities of HK$8.58b due within 12 months and liabilities of HK$7.47b due beyond that. Offsetting this, it had HK$1.18b in cash and HK$5.40b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$9.46b.

Lee and Man Paper Manufacturing has a market capitalization of HK$30.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Lee and Man Paper Manufacturing's moderate net debt to EBITDA ratio ( being 2.5), indicates prudence when it comes to debt. And its commanding EBIT of 28.9 times its interest expense, implies the debt load is as light as a peacock feather. We note that Lee and Man Paper Manufacturing grew its EBIT by 20% 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 ultimately the future profitability of the business will decide if Lee and Man Paper Manufacturing can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Lee and Man Paper Manufacturing recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Lee and Man Paper Manufacturing's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Lee and Man Paper Manufacturing can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For example, we've discovered 1 warning sign for Lee and Man Paper Manufacturing that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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