Is Prosper Construction Holdings (HKG:6816) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Prosper Construction Holdings Limited (HKG:6816) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Prosper Construction Holdings

How Much Debt Does Prosper Construction Holdings Carry?

As you can see below, at the end of June 2022, Prosper Construction Holdings had HK$1.34b of debt, up from HK$832.0m a year ago. Click the image for more detail. However, it also had HK$780.1m in cash, and so its net debt is HK$556.7m.

How Healthy Is Prosper Construction Holdings' Balance Sheet?

We can see from the most recent balance sheet that Prosper Construction Holdings had liabilities of HK$3.32b falling due within a year, and liabilities of HK$602.7m due beyond that. Offsetting these obligations, it had cash of HK$780.1m as well as receivables valued at HK$3.15b due within 12 months. So these liquid assets roughly match the total liabilities.

This surplus suggests that Prosper Construction Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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.

While we wouldn't worry about Prosper Construction Holdings's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 1.7 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that Prosper Construction Holdings grew its EBIT a smooth 86% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Prosper Construction Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Prosper Construction Holdings 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

Prosper Construction Holdings's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Prosper Construction Holdings is a somewhat risky investment as a result of its debt. 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. Be aware that Prosper Construction Holdings is showing 5 warning signs in our investment analysis , and 2 of those are a bit concerning...

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. 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.