LVGEM (China) Real Estate Investment (HKG:95) Seems To Be Using A Lot Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that LVGEM (China) Real Estate Investment Company Limited (HKG:95) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for LVGEM (China) Real Estate Investment

What Is LVGEM (China) Real Estate Investment's Debt?

The chart below, which you can click on for greater detail, shows that LVGEM (China) Real Estate Investment had CN¥35.7b in debt in June 2024; about the same as the year before. On the flip side, it has CN¥812.4m in cash leading to net debt of about CN¥34.9b.

How Strong Is LVGEM (China) Real Estate Investment's Balance Sheet?

The latest balance sheet data shows that LVGEM (China) Real Estate Investment had liabilities of CN¥37.1b due within a year, and liabilities of CN¥40.0b falling due after that. Offsetting this, it had CN¥812.4m in cash and CN¥324.8m in receivables that were due within 12 months. So it has liabilities totalling CN¥76.0b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥2.32b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, LVGEM (China) Real Estate Investment would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.41 times and a disturbingly high net debt to EBITDA ratio of 45.2 hit our confidence in LVGEM (China) Real Estate Investment like a one-two punch to the gut. The debt burden here is substantial. Looking on the bright side, LVGEM (China) Real Estate Investment boosted its EBIT by a silky 41% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is LVGEM (China) Real Estate Investment's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, LVGEM (China) Real Estate Investment burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, LVGEM (China) Real Estate Investment's conversion of EBIT to free cash flow 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 growing its EBIT; that's encouraging. Taking into account all the aforementioned factors, it looks like LVGEM (China) Real Estate Investment has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that LVGEM (China) Real Estate Investment is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

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.