These 4 Measures Indicate That China Overseas Land & Investment (HKG:688) Is Using Debt In A Risky Way

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.' 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. As with many other companies China Overseas Land & Investment Limited (HKG:688) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 China Overseas Land & Investment

What Is China Overseas Land & Investment's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 China Overseas Land & Investment had debt of CN¥281.2b, up from CN¥251.6b in one year. On the flip side, it has CN¥109.7b in cash leading to net debt of about CN¥171.5b.

How Healthy Is China Overseas Land & Investment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Overseas Land & Investment had liabilities of CN¥281.2b due within 12 months and liabilities of CN¥259.0b due beyond that. Offsetting this, it had CN¥109.7b in cash and CN¥25.3b in receivables that were due within 12 months. So it has liabilities totalling CN¥405.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥157.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Overseas Land & Investment would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Strangely China Overseas Land & Investment has a sky high EBITDA ratio of 5.7, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that China Overseas Land & Investment's EBIT was down 41% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Overseas Land & Investment's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, China Overseas Land & Investment created free cash flow amounting to 17% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, China Overseas Land & Investment's EBIT growth rate 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 covering its interest expense with its EBIT; that's encouraging. Taking into account all the aforementioned factors, it looks like China Overseas Land & Investment has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 example China Overseas Land & Investment has 3 warning signs (and 1 which is concerning) we think you should know about.

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.