Here's Why Deson Development International Holdings (HKG:262) Is Weighed Down By Its Debt Load

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Deson Development International Holdings Limited (HKG:262) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Deson Development International Holdings

What Is Deson Development International Holdings's Debt?

The image below, which you can click on for greater detail, shows that Deson Development International Holdings had debt of HK$445.8m at the end of September 2022, a reduction from HK$488.1m over a year. However, it does have HK$24.7m in cash offsetting this, leading to net debt of about HK$421.1m.

How Strong Is Deson Development International Holdings' Balance Sheet?

The latest balance sheet data shows that Deson Development International Holdings had liabilities of HK$286.8m due within a year, and liabilities of HK$433.6m falling due after that. Offsetting these obligations, it had cash of HK$24.7m as well as receivables valued at HK$37.8m due within 12 months. So it has liabilities totalling HK$658.0m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$95.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Deson Development International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Deson Development International Holdings's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 5.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably, Deson Development International Holdings made a loss at the EBIT level, last year, but improved that to positive EBIT of HK$128m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Deson Development International Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Deson Development International Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Mulling over Deson Development International Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Overall, it seems to us that Deson Development International Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 2 warning signs for Deson Development International Holdings (1 can't be ignored) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.