Is Shun Ho Property Investments (HKG:219) A Risky Investment?

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 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. As with many other companies Shun Ho Property Investments Limited (HKG:219) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. 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. 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 Shun Ho Property Investments

What Is Shun Ho Property Investments's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Shun Ho Property Investments had HK$1.24b of debt, an increase on HK$934.6m, over one year. However, it does have HK$499.1m in cash offsetting this, leading to net debt of about HK$737.1m.

A Look At Shun Ho Property Investments's Liabilities

Zooming in on the latest balance sheet data, we can see that Shun Ho Property Investments had liabilities of HK$694.8m due within 12 months and liabilities of HK$843.3m due beyond that. On the other hand, it had cash of HK$499.1m and HK$20.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.02b.

Given this deficit is actually higher than the company's market capitalization of HK$767.4m, we think shareholders really should watch Shun Ho Property Investments's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 5.5 hit our confidence in Shun Ho Property Investments like a one-two punch to the gut. The debt burden here is substantial. Worse, Shun Ho Property Investments's EBIT was down 93% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shun Ho Property Investments'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Shun Ho Property Investments actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Shun Ho Property Investments's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Shun Ho Property Investments to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 2 warning signs for Shun Ho Property Investments (1 can't be ignored) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.
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