Longchen Paper & Packaging (TPE:1909) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Longchen Paper & Packaging Co., Ltd. (TPE:1909) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Longchen Paper & Packaging

What Is Longchen Paper & Packaging's Debt?

As you can see below, Longchen Paper & Packaging had NT$39.3b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has NT$1.39b in cash leading to net debt of about NT$37.9b.

How Healthy Is Longchen Paper & Packaging's Balance Sheet?

According to the last reported balance sheet, Longchen Paper & Packaging had liabilities of NT$25.6b due within 12 months, and liabilities of NT$22.6b due beyond 12 months. Offsetting these obligations, it had cash of NT$1.39b as well as receivables valued at NT$10.8b due within 12 months. So its liabilities total NT$36.1b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's NT$33.9b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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

Longchen Paper & Packaging shareholders face the double whammy of a high net debt to EBITDA ratio (8.0), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we'd consider it to have a heavy debt load. On a lighter note, we note that Longchen Paper & Packaging grew its EBIT by 29% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But it is Longchen Paper & Packaging's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Longchen Paper & Packaging burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Longchen Paper & Packaging's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Longchen Paper & Packaging to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Case in point: We've spotted 4 warning signs for Longchen Paper & Packaging you should be aware of, and 2 of them don't sit too well with us.

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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