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.' 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. We can see that Nine Dragons Paper (Holdings) Limited (HKG:2689) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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?

As you can see below, at the end of December 2021, Nine Dragons Paper (Holdings) had CN¥34.7b of debt, up from CN¥25.9b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥8.24b, its net debt is less, at about CN¥26.5b.

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

We can see from the most recent balance sheet that Nine Dragons Paper (Holdings) had liabilities of CN¥27.4b falling due within a year, and liabilities of CN¥21.4b due beyond that. On the other hand, it had cash of CN¥8.24b and CN¥7.88b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥32.6b.

Given this deficit is actually higher than the company's market capitalization of CN¥30.4b, we think shareholders really should watch Nine Dragons Paper (Holdings)'s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Nine Dragons Paper (Holdings) has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 12.2 is very high, suggesting that the interest expense on the debt is currently quite low. The bad news is that Nine Dragons Paper (Holdings) saw its EBIT decline by 15% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. 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, Nine Dragons Paper (Holdings) created free cash flow amounting to 16% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Nine Dragons Paper (Holdings)'s level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that Nine Dragons Paper (Holdings) has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Nine Dragons Paper (Holdings) (at least 1 which is concerning) , and understanding them should be part of your investment process.

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. 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.