These 4 Measures Indicate That Lee & Man Chemical (HKG:746) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Lee & Man Chemical Company Limited (HKG:746) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Lee & Man Chemical

What Is Lee & Man Chemical's Debt?

The chart below, which you can click on for greater detail, shows that Lee & Man Chemical had HK$1.53b in debt in December 2020; about the same as the year before. However, it also had HK$386.6m in cash, and so its net debt is HK$1.15b.

How Healthy Is Lee & Man Chemical's Balance Sheet?

According to the last reported balance sheet, Lee & Man Chemical had liabilities of HK$1.17b due within 12 months, and liabilities of HK$1.16b due beyond 12 months. Offsetting this, it had HK$386.6m in cash and HK$308.7m in receivables that were due within 12 months. So its liabilities total HK$1.64b more than the combination of its cash and short-term receivables.

Lee & Man Chemical has a market capitalization of HK$3.38b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Lee & Man Chemical's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 11.1 times its interest expense, implies the debt load is as light as a peacock feather. Shareholders should be aware that Lee & Man Chemical's EBIT was down 32% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Lee & Man Chemical will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Lee & Man Chemical produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Lee & Man Chemical's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. We think that Lee & Man Chemical's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example - Lee & Man Chemical has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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