SOHO China (HKG:410) Use Of Debt Could Be Considered Risky

Warren Buffett famously said, '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. Importantly, SOHO China Limited (HKG:410) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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.

See our latest analysis for SOHO China

How Much Debt Does SOHO China Carry?

You can click the graphic below for the historical numbers, but it shows that SOHO China had CN¥18.4b of debt in December 2019, down from CN¥21.1b, one year before. However, because it has a cash reserve of CN¥1.21b, its net debt is less, at about CN¥17.2b.

How Strong Is SOHO China's Balance Sheet?

We can see from the most recent balance sheet that SOHO China had liabilities of CN¥6.85b falling due within a year, and liabilities of CN¥25.8b due beyond that. On the other hand, it had cash of CN¥1.21b and CN¥454.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥31.0b.

The deficiency here weighs heavily on the CN¥13.4b 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'd watch its balance sheet closely, without a doubt. At the end of the day, SOHO China would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

SOHO China shareholders face the double whammy of a high net debt to EBITDA ratio (11.2), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that SOHO China actually let its EBIT decrease by 4.9% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if SOHO China 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.

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, SOHO China burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, SOHO China's conversion of EBIT to free cash flow 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. And furthermore, its interest cover also fails to instill confidence. Considering all the factors previously mentioned, we think that SOHO China really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Be aware that SOHO China is showing 5 warning signs in our investment analysis , and 2 of those can't be ignored...

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. 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. Thank you for reading.