Lee & Man Paper Manufacturing (HKG:2314) Takes On Some Risk With Its Use Of Debt

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 Lee & Man Paper Manufacturing Limited (HKG:2314) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Lee & Man Paper Manufacturing

How Much Debt Does Lee & Man Paper Manufacturing Carry?

The image below, which you can click on for greater detail, shows that at December 2021 Lee & Man Paper Manufacturing had debt of HK$14.1b, up from HK$11.3b in one year. On the flip side, it has HK$1.91b in cash leading to net debt of about HK$12.2b.

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$12.2b due within 12 months, and liabilities of HK$6.86b due beyond 12 months. On the other hand, it had cash of HK$1.91b and HK$6.13b worth of receivables due within a year. So it has liabilities totalling HK$11.0b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$16.1b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Lee & Man Paper Manufacturing's net debt is 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 69.7 is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that Lee & Man Paper Manufacturing's EBIT was down 21% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. In the last three years, Lee & Man Paper Manufacturing created free cash flow amounting to 9.6% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Lee & Man Paper Manufacturing's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Lee & Man Paper Manufacturing has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Be aware that Lee & Man Paper Manufacturing is showing 2 warning signs in our investment analysis , 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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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.