We Think Wharf Real Estate Investment (HKG:1997) Is Taking Some Risk With Its 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Wharf Real Estate Investment Company Limited (HKG:1997) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Wharf Real Estate Investment

What Is Wharf Real Estate Investment's Debt?

The image below, which you can click on for greater detail, shows that Wharf Real Estate Investment had debt of HK$39.6b at the end of December 2023, a reduction from HK$49.6b over a year. However, because it has a cash reserve of HK$977.0m, its net debt is less, at about HK$38.6b.

A Look At Wharf Real Estate Investment's Liabilities

We can see from the most recent balance sheet that Wharf Real Estate Investment had liabilities of HK$14.7b falling due within a year, and liabilities of HK$35.0b due beyond that. On the other hand, it had cash of HK$977.0m and HK$1.22b worth of receivables due within a year. So its liabilities total HK$47.5b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$75.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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).

Wharf Real Estate Investment has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 4.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Wharf Real Estate Investment could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Wharf Real Estate Investment can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Wharf Real Estate Investment recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Wharf Real Estate Investment's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its EBIT growth rate gives us reason to be optimistic. Looking at all the angles mentioned above, it does seem to us that Wharf Real Estate Investment is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Wharf Real Estate Investment is showing 2 warning signs in our investment analysis , you should know about...

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.