Hon Kwok Land Investment Company (HKG:160) Has A Somewhat Strained 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 Hon Kwok Land Investment Company, Limited (HKG:160) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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.

Check out our latest analysis for Hon Kwok Land Investment Company

What Is Hon Kwok Land Investment Company's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Hon Kwok Land Investment Company had debt of HK$6.30b, up from HK$5.61b in one year. On the flip side, it has HK$1.82b in cash leading to net debt of about HK$4.48b.

How Strong Is Hon Kwok Land Investment Company's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hon Kwok Land Investment Company had liabilities of HK$1.55b due within 12 months and liabilities of HK$6.95b due beyond that. Offsetting these obligations, it had cash of HK$1.82b as well as receivables valued at HK$29.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$6.65b.

This deficit casts a shadow over the HK$893.3m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Hon Kwok Land Investment Company 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 9.4 hit our confidence in Hon Kwok Land Investment Company like a one-two punch to the gut. The debt burden here is substantial. However, one redeeming factor is that Hon Kwok Land Investment Company grew its EBIT at 11% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Hon Kwok Land Investment Company'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 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. Over the most recent three years, Hon Kwok Land Investment Company recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Hon Kwok Land Investment Company's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Hon Kwok Land Investment Company has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Hon Kwok Land Investment Company you should be aware of, and 1 of them is a bit concerning.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.