Is Wharf (Holdings) (HKG:4) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Wharf (Holdings) Limited (HKG:4) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Wharf (Holdings)

What Is Wharf (Holdings)'s Net Debt?

The image below, which you can click on for greater detail, shows that Wharf (Holdings) had debt of HK$20.0b at the end of December 2022, a reduction from HK$36.7b over a year. However, it does have HK$14.6b in cash offsetting this, leading to net debt of about HK$5.32b.

A Look At Wharf (Holdings)'s Liabilities

According to the last reported balance sheet, Wharf (Holdings) had liabilities of HK$33.4b due within 12 months, and liabilities of HK$32.6b due beyond 12 months. Offsetting this, it had HK$14.6b in cash and HK$1.76b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$49.6b.

This deficit is considerable relative to its market capitalization of HK$54.1b, so it does suggest shareholders should keep an eye on Wharf (Holdings)'s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Wharf (Holdings) has a low net debt to EBITDA ratio of only 0.73. And its EBIT covers its interest expense a whopping 12.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Wharf (Holdings)'s saving grace is its low debt levels, because its EBIT has tanked 23% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Wharf (Holdings) 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Wharf (Holdings) recorded free cash flow worth 72% 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 (Holdings)'s EBIT growth rate has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. We think that Wharf (Holdings)'s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given our hesitation about the stock, it would be good to know if Wharf (Holdings) insiders have sold any shares recently. You click here to find out if insiders have sold recently.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.