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

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.' 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. As with many other companies Lee & Man Paper Manufacturing Limited (HKG:2314) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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 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?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Lee & Man Paper Manufacturing had HK$17.8b of debt, an increase on HK$15.5b, over one year. On the flip side, it has HK$2.23b in cash leading to net debt of about HK$15.6b.

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

According to the last reported balance sheet, Lee & Man Paper Manufacturing had liabilities of HK$12.4b due within 12 months, and liabilities of HK$11.4b due beyond 12 months. Offsetting this, it had HK$2.23b in cash and HK$4.79b in receivables that were due within 12 months. So its liabilities total HK$16.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$9.87b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Lee & Man Paper Manufacturing would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Lee & Man Paper Manufacturing shareholders face the double whammy of a high net debt to EBITDA ratio (51.7), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. The debt burden here is substantial. Worse, Lee & Man Paper Manufacturing's EBIT was down 88% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Lee & Man Paper Manufacturing's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. It looks to us like Lee & Man Paper Manufacturing carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Lee & Man Paper Manufacturing (including 1 which is a bit unpleasant) .

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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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.