Lee & Man Paper Manufacturing (HKG:2314) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that Lee & Man Paper Manufacturing Limited (HKG:2314) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Lee & Man Paper Manufacturing

How Much Debt Does Lee & Man Paper Manufacturing Carry?

As you can see below, at the end of December 2022, Lee & Man Paper Manufacturing had HK$16.3b of debt, up from HK$14.1b a year ago. Click the image for more detail. However, it also had HK$1.80b in cash, and so its net debt is HK$14.5b.

How Healthy Is Lee & Man Paper Manufacturing's Balance Sheet?

The latest balance sheet data shows that Lee & Man Paper Manufacturing had liabilities of HK$12.3b due within a year, and liabilities of HK$9.43b falling due after that. Offsetting these obligations, it had cash of HK$1.80b as well as receivables valued at HK$4.94b due within 12 months. So its liabilities total HK$15.0b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's HK$11.9b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

With a net debt to EBITDA ratio of 17.6, it's fair to say Lee & Man Paper Manufacturing does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 7.0 times, suggesting it can responsibly service its obligations. Shareholders should be aware that Lee & Man Paper Manufacturing's EBIT was down 78% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lee & 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Lee & Man Paper Manufacturing recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Lee & Man Paper Manufacturing's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think Lee & Man Paper Manufacturing has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Lee & Man Paper Manufacturing you should be aware of.

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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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.