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 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 can see that Lee & Man Paper Manufacturing Limited (HKG:2314) does use debt in its business. 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. 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, 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.
What Is Lee & Man Paper Manufacturing's Net Debt?
As you can see below, at the end of June 2022, Lee & Man Paper Manufacturing had HK$15.5b of debt, up from HK$14.0b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$1.83b, its net debt is less, at about HK$13.7b.
How Strong Is Lee & Man Paper Manufacturing's Balance Sheet?
We can see from the most recent balance sheet that Lee & Man Paper Manufacturing had liabilities of HK$12.7b falling due within a year, and liabilities of HK$7.31b due beyond that. Offsetting this, it had HK$1.83b in cash and HK$5.42b in receivables that were due within 12 months. So it has liabilities totalling HK$12.8b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of HK$13.1b, so it does suggest shareholders should keep an eye on Lee & Man Paper Manufacturing's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
As it happens Lee & Man Paper Manufacturing has a fairly concerning net debt to EBITDA ratio of 7.4 but very strong interest coverage of 37.4. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Lee & Man Paper Manufacturing's EBIT was down 64% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Lee & Man Paper Manufacturing'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Lee & Man Paper Manufacturing actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Lee & Man Paper Manufacturing's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Lee & Man Paper Manufacturing's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Lee & Man Paper Manufacturing you should know about.
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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Lee & Man Paper Manufacturing
Lee & Man Paper Manufacturing Limited, an investment holding company, manufactures and trades in packaging papers, pulps, and tissue papers in the People’s Republic of China, Vietnam, Malaysia, Macau, and Hong Kong.
Excellent balance sheet and fair value.