Prosper Construction Holdings (HKG:6816) Seems To Use Debt Quite Sensibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Prosper Construction Holdings Limited (HKG:6816) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, 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 2021, Prosper Construction Holdings had HK$832.0m of debt, up from HK$245.7m a year ago. Click the image for more detail. However, because it has a cash reserve of HK$440.3m, its net debt is less, at about HK$391.7m.

A Look At Prosper Construction Holdings' Liabilities

We can see from the most recent balance sheet that Prosper Construction Holdings had liabilities of HK$1.64b falling due within a year, and liabilities of HK$422.8m due beyond that. On the other hand, it had cash of HK$440.3m and HK$1.67b worth of receivables due within a year. So it actually has HK$49.9m more liquid assets than total liabilities.

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

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.

With a net debt to EBITDA ratio of 5.6, it's fair to say Prosper Construction Holdings does have a significant amount of debt. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. The good news is that Prosper Construction Holdings grew its EBIT a smooth 74% 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Prosper Construction Holdings 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Prosper Construction Holdings saw substantial negative free cash flow, in total. 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 was a real negative on this analysis, as was its net debt to EBITDA. But its EBIT growth rate was significantly redeeming. Looking at all this data makes us feel a little cautious about Prosper Construction Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For example Prosper Construction Holdings has 5 warning signs (and 2 which are concerning) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.
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