These 4 Measures Indicate That Nine Dragons Paper (Holdings) (HKG:2689) Is Using Debt In A Risky Way

Warren Buffett famously said, '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. 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?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Nine Dragons Paper (Holdings)

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

The image below, which you can click on for greater detail, shows that at June 2022 Nine Dragons Paper (Holdings) had debt of CN¥44.2b, up from CN¥34.1b in one year. However, it also had CN¥9.78b in cash, and so its net debt is CN¥34.5b.

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

According to the last reported balance sheet, Nine Dragons Paper (Holdings) had liabilities of CN¥18.2b due within 12 months, and liabilities of CN¥41.4b due beyond 12 months. Offsetting these obligations, it had cash of CN¥9.78b as well as receivables valued at CN¥10.6b due within 12 months. So it has liabilities totalling CN¥39.2b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥20.3b 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 definitely think shareholders need to watch this one closely. At the end of the day, Nine Dragons Paper (Holdings) would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Nine Dragons Paper (Holdings) has a rather high debt to EBITDA ratio of 5.2 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 6.3 times, suggesting it can responsibly service its obligations. Importantly, Nine Dragons Paper (Holdings)'s EBIT fell a jaw-dropping 57% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Nine Dragons Paper (Holdings) created free cash flow amounting to 20% 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 EBIT growth rate 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 its interest cover is not so bad. Taking into account all the aforementioned factors, it looks like Nine Dragons Paper (Holdings) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Nine Dragons Paper (Holdings) (1 can't be ignored!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.