These 4 Measures Indicate That Hongkong and Shanghai Hotels (HKG:45) Is Using Debt Extensively

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. Importantly, The Hongkong and Shanghai Hotels, Limited (HKG:45) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hongkong and Shanghai Hotels

What Is Hongkong and Shanghai Hotels's Debt?

You can click the graphic below for the historical numbers, but it shows that Hongkong and Shanghai Hotels had HK$14.8b of debt in June 2024, down from HK$16.9b, one year before. However, it does have HK$758.0m in cash offsetting this, leading to net debt of about HK$14.1b.

How Healthy Is Hongkong and Shanghai Hotels' Balance Sheet?

We can see from the most recent balance sheet that Hongkong and Shanghai Hotels had liabilities of HK$5.65b falling due within a year, and liabilities of HK$14.4b due beyond that. Offsetting this, it had HK$758.0m in cash and HK$385.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$18.9b.

This deficit casts a shadow over the HK$10.8b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hongkong and Shanghai Hotels would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 11.4 hit our confidence in Hongkong and Shanghai Hotels like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, it should be some comfort for shareholders to recall that Hongkong and Shanghai Hotels actually grew its EBIT by a hefty 173%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hongkong and Shanghai Hotels 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 two years, Hongkong and Shanghai Hotels 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

We feel some trepidation about Hongkong and Shanghai Hotels's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Taking the abovementioned factors together we do think Hongkong and Shanghai Hotels's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Hongkong and Shanghai Hotels 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.