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 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. Importantly, Nine Dragons Paper (Holdings) Limited (HKG:2689) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

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

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

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Nine Dragons Paper (Holdings) had CN¥34.1b of debt, an increase on CN¥26.3b, over one year. However, it also had CN¥10.1b in cash, and so its net debt is CN¥24.0b.

A Look At Nine Dragons Paper (Holdings)'s Liabilities

Zooming in on the latest balance sheet data, we can see that Nine Dragons Paper (Holdings) had liabilities of CN¥23.9b due within 12 months and liabilities of CN¥21.8b due beyond that. On the other hand, it had cash of CN¥10.1b and CN¥10.3b worth of receivables due within a year. So its liabilities total CN¥25.3b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥40.0b, so it does suggest shareholders should keep an eye on Nine Dragons Paper (Holdings)'s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Nine Dragons Paper (Holdings)'s net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 17.3 times, makes us even more comfortable. It is well worth noting that Nine Dragons Paper (Holdings)'s EBIT shot up like bamboo after rain, gaining 38% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Nine Dragons Paper (Holdings) 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Nine Dragons Paper (Holdings) recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Nine Dragons Paper (Holdings)'s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Nine Dragons Paper (Holdings) can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For instance, we've identified 2 warning signs for Nine Dragons Paper (Holdings) (1 is potentially serious) you should be aware of.

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.

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.

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