These 4 Measures Indicate That Royale Home Holdings (HKG:1198) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Royale Home Holdings Limited (HKG:1198) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Royale Home Holdings

What Is Royale Home Holdings's Debt?

As you can see below, at the end of June 2021, Royale Home Holdings had HK$1.71b of debt, up from HK$348.2m a year ago. Click the image for more detail. However, because it has a cash reserve of HK$886.6m, its net debt is less, at about HK$818.6m.

A Look At Royale Home Holdings' Liabilities

According to the last reported balance sheet, Royale Home Holdings had liabilities of HK$1.35b due within 12 months, and liabilities of HK$1.51b due beyond 12 months. On the other hand, it had cash of HK$886.6m and HK$48.9m worth of receivables due within a year. So it has liabilities totalling HK$1.92b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Royale Home Holdings is worth HK$6.44b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Royale Home Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (8.2), and fairly weak interest coverage, since EBIT is just 0.77 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Royale Home Holdings achieved a positive EBIT of HK$45m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But it is Royale Home Holdings's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Royale Home Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Royale Home Holdings's interest cover was a real negative on this analysis, as was its net debt to EBITDA. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Royale Home 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Royale Home Holdings is showing 1 warning sign in our investment analysis , you should know about...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.