Here's Why Wharf (Holdings) (HKG:4) Has A Meaningful Debt Burden

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that The Wharf (Holdings) Limited (HKG:4) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

View our latest analysis for Wharf (Holdings)

What Is Wharf (Holdings)'s Debt?

You can click the graphic below for the historical numbers, but it shows that Wharf (Holdings) had HK$23.9b of debt in June 2023, down from HK$29.3b, one year before. However, because it has a cash reserve of HK$8.86b, its net debt is less, at about HK$15.0b.

How Strong Is Wharf (Holdings)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Wharf (Holdings) had liabilities of HK$31.4b due within 12 months and liabilities of HK$34.5b due beyond that. On the other hand, it had cash of HK$8.86b and HK$1.98b worth of receivables due within a year. So it has liabilities totalling HK$55.0b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$72.9b. 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 (Holdings)'s net debt of 2.2 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.4 times interest expense) certainly does not do anything to dispel this impression. Unfortunately, Wharf (Holdings)'s EBIT flopped 19% 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. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Wharf (Holdings)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Wharf (Holdings) produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Wharf (Holdings)'s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. Taking the abovementioned factors together we do think Wharf (Holdings)'s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.