Chi Ho Development Holdings (HKG:8423) Seems To Use Debt Quite Sensibly

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.' 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 Chi Ho Development Holdings Limited (HKG:8423) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Chi Ho Development Holdings

What Is Chi Ho Development Holdings's Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Chi Ho Development Holdings had debt of HK$88.8m, up from HK$40.7m in one year. However, it does have HK$51.3m in cash offsetting this, leading to net debt of about HK$37.6m.

A Look At Chi Ho Development Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Chi Ho Development Holdings had liabilities of HK$157.1m due within 12 months and liabilities of HK$3.75m due beyond that. Offsetting this, it had HK$51.3m in cash and HK$215.5m in receivables that were due within 12 months. So it actually has HK$106.0m more liquid assets than total liabilities.

This luscious liquidity implies that Chi Ho Development Holdings' balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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).

With a debt to EBITDA ratio of 2.0, Chi Ho Development Holdings uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.7 times interest expense) certainly does not do anything to dispel this impression. Importantly, Chi Ho Development Holdings's EBIT fell a jaw-dropping 31% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Chi Ho Development 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 company can only pay off debt with cold hard cash, not accounting profits. 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, Chi Ho Development Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

We weren't impressed with Chi Ho Development Holdings's conversion of EBIT to free cash flow, and its EBIT growth rate made us cautious. But its level of total liabilities was significantly redeeming. When we consider all the factors mentioned above, we do feel a bit cautious about Chi Ho Development Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For instance, we've identified 5 warning signs for Chi Ho Development Holdings (2 are concerning) you should be aware of.

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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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.