Sun Hung Kai Properties (HKG:16) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Sun Hung Kai Properties Limited (HKG:16) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sun Hung Kai Properties

What Is Sun Hung Kai Properties's Debt?

As you can see below, at the end of December 2022, Sun Hung Kai Properties had HK$131.9b of debt, up from HK$122.9b a year ago. Click the image for more detail. On the flip side, it has HK$18.5b in cash leading to net debt of about HK$113.4b.

A Look At Sun Hung Kai Properties' Liabilities

The latest balance sheet data shows that Sun Hung Kai Properties had liabilities of HK$63.0b due within a year, and liabilities of HK$138.9b falling due after that. On the other hand, it had cash of HK$18.5b and HK$13.9b worth of receivables due within a year. So it has liabilities totalling HK$169.5b more than its cash and near-term receivables, combined.

Sun Hung Kai Properties has a very large market capitalization of HK$317.9b, so it could very likely raise cash to ameliorate 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).

Sun Hung Kai Properties has a debt to EBITDA ratio of 3.9, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 14.5 is very high, suggesting that the interest expense on the debt is currently quite low. Unfortunately, Sun Hung Kai Properties's EBIT flopped 18% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sun Hung Kai Properties can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sun Hung Kai Properties produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Sun Hung Kai Properties's EBIT growth rate and net debt to EBITDA definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Sun Hung Kai Properties is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example - Sun Hung Kai Properties has 1 warning sign we think 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.