These 4 Measures Indicate That Lee & Man Paper Manufacturing (HKG:2314) Is Using Debt In A Risky Way

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 & Man Paper Manufacturing Limited (HKG:2314) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

Check out our latest analysis for Lee & Man Paper Manufacturing

What Is Lee & Man Paper Manufacturing's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Lee & Man Paper Manufacturing had debt of HK$19.3b, up from HK$16.3b in one year. However, it also had HK$1.52b in cash, and so its net debt is HK$17.8b.

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

Zooming in on the latest balance sheet data, we can see that Lee & Man Paper Manufacturing had liabilities of HK$11.4b due within 12 months and liabilities of HK$13.9b due beyond that. Offsetting this, it had HK$1.52b in cash and HK$6.70b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$17.1b.

The deficiency here weighs heavily on the HK$10.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Lee & Man Paper Manufacturing would likely require a major re-capitalisation if it had to pay its creditors today.

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

With a net debt to EBITDA ratio of 19.8, 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 3.0 times, suggesting it can responsibly service its obligations. On a slightly more positive note, Lee & Man Paper Manufacturing grew its EBIT at 14% over the last year, further increasing its ability to manage debt. 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 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. During the last three years, Lee & Man Paper Manufacturing burned a lot of cash. 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

On the face of it, Lee & Man Paper Manufacturing's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Taking into account all the aforementioned factors, it looks like 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. For example Lee & Man Paper Manufacturing has 2 warning signs (and 1 which is significant) we think you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com