Is Nine Dragons Paper (Holdings) (HKG:2689) Using Too Much 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.' 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 note that Nine Dragons Paper (Holdings) Limited (HKG:2689) does have debt on its balance sheet. But is this debt a concern to shareholders?

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

Check out our latest analysis for Nine Dragons Paper (Holdings)

What Is Nine Dragons Paper (Holdings)'s Debt?

As you can see below, Nine Dragons Paper (Holdings) had CN¥25.9b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥6.67b in cash offsetting this, leading to net debt of about CN¥19.3b.

How Strong Is Nine Dragons Paper (Holdings)'s Balance Sheet?

The latest balance sheet data shows that Nine Dragons Paper (Holdings) had liabilities of CN¥20.9b due within a year, and liabilities of CN¥18.9b falling due after that. On the other hand, it had cash of CN¥6.67b and CN¥8.83b worth of receivables due within a year. So it has liabilities totalling CN¥24.3b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Nine Dragons Paper (Holdings) is worth CN¥46.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

Nine Dragons Paper (Holdings)'s net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 15.9 times its interest expense, implies the debt load is as light as a peacock feather. It is well worth noting that Nine Dragons Paper (Holdings)'s EBIT shot up like bamboo after rain, gaining 34% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Nine Dragons Paper (Holdings)'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Nine Dragons Paper (Holdings) recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Nine Dragons Paper (Holdings)'s ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Nine Dragons Paper (Holdings) is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Nine Dragons Paper (Holdings) (1 is significant) you should be aware of.

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.

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This article by Simply Wall St is general in nature. 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.
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