Does Hongkong and Shanghai Hotels (HKG:45) Have A Healthy Balance Sheet?

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 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 The Hongkong and Shanghai Hotels, Limited (HKG:45) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Hongkong and Shanghai Hotels

How Much Debt Does Hongkong and Shanghai Hotels Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Hongkong and Shanghai Hotels had HK$16.9b of debt, an increase on HK$13.8b, over one year. However, it also had HK$623.0m in cash, and so its net debt is HK$16.3b.

How Strong Is Hongkong and Shanghai Hotels' Balance Sheet?

According to the last reported balance sheet, Hongkong and Shanghai Hotels had liabilities of HK$5.17b due within 12 months, and liabilities of HK$17.0b due beyond 12 months. Offsetting these obligations, it had cash of HK$623.0m as well as receivables valued at HK$344.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$21.2b.

The deficiency here weighs heavily on the HK$9.76b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Hongkong and Shanghai Hotels would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hongkong and Shanghai Hotels shareholders face the double whammy of a high net debt to EBITDA ratio (25.0), and fairly weak interest coverage, since EBIT is just 0.78 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Hongkong and Shanghai Hotels achieved a positive EBIT of HK$241m 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 Hongkong and Shanghai Hotels's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Hongkong and Shanghai Hotels saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Hongkong and Shanghai Hotels's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Considering all the factors previously mentioned, we think that Hongkong and Shanghai Hotels really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Hongkong and Shanghai Hotels .

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.