Here's Why Longfor Group Holdings (HKG:960) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Longfor Group Holdings Limited (HKG:960) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Longfor Group Holdings

What Is Longfor Group Holdings's Debt?

The image below, which you can click on for greater detail, shows that Longfor Group Holdings had debt of CN¥203.5b at the end of June 2024, a reduction from CN¥224.8b over a year. On the flip side, it has CN¥48.9b in cash leading to net debt of about CN¥154.6b.

How Healthy Is Longfor Group Holdings' Balance Sheet?

According to the last reported balance sheet, Longfor Group Holdings had liabilities of CN¥262.8b due within 12 months, and liabilities of CN¥189.3b due beyond 12 months. Offsetting this, it had CN¥48.9b in cash and CN¥105.0b in receivables that were due within 12 months. So its liabilities total CN¥298.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥82.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Longfor Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Longfor Group Holdings has a sky high EBITDA ratio of 9.1, implying high debt, but a strong interest coverage of 91.7. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Longfor Group Holdings's EBIT was down 53% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Longfor Group Holdings can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Longfor Group Holdings recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Longfor Group Holdings'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. We're quite clear that we consider Longfor Group Holdings to be really rather risky, as a result of its balance sheet health. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 5 warning signs we've spotted with Longfor Group Holdings (including 1 which shouldn't be ignored) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.