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’. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that LVGEM (China) Real Estate Investment Company Limited (HKG:95) does use debt in its business. 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. 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.
What Is LVGEM (China) Real Estate Investment’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 LVGEM (China) Real Estate Investment had CN¥24.0b of debt, an increase on CN¥20.3b, over one year. On the flip side, it has CN¥5.84b in cash leading to net debt of about CN¥18.2b.
How Strong Is LVGEM (China) Real Estate Investment’s Balance Sheet?
The latest balance sheet data shows that LVGEM (China) Real Estate Investment had liabilities of CN¥14.6b due within a year, and liabilities of CN¥20.0b falling due after that. Offsetting this, it had CN¥5.84b in cash and CN¥218.1m in receivables that were due within 12 months. So it has liabilities totalling CN¥28.6b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥12.2b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. After all, LVGEM (China) Real Estate Investment would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
LVGEM (China) Real Estate Investment has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 5.6 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Pleasingly, LVGEM (China) Real Estate Investment is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 162% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since LVGEM (China) Real Estate Investment 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, LVGEM (China) Real Estate Investment produced sturdy free cash flow equating to 67% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
LVGEM (China) Real Estate Investment’s level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think LVGEM (China) Real Estate Investment’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that LVGEM (China) Real Estate Investment is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable…
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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