Is Hang Lung Group (HKG:10) A Risky Investment?

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 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. As with many other companies Hang Lung Group Limited (HKG:10) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hang Lung Group

How Much Debt Does Hang Lung Group Carry?

As you can see below, at the end of June 2021, Hang Lung Group had HK$41.3b of debt, up from HK$33.9b a year ago. Click the image for more detail. However, it also had HK$3.56b in cash, and so its net debt is HK$37.7b.

How Strong Is Hang Lung Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hang Lung Group had liabilities of HK$18.8b due within 12 months and liabilities of HK$48.4b due beyond that. Offsetting this, it had HK$3.56b in cash and HK$2.82b in receivables that were due within 12 months. So its liabilities total HK$60.8b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$21.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Hang Lung Group would probably need a major re-capitalization if its creditors were to demand repayment.

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).

As it happens Hang Lung Group has a fairly concerning net debt to EBITDA ratio of 5.5 but very strong interest coverage of 31.9. So either it has access to very cheap long term debt or that interest expense is going to grow! If Hang Lung Group can keep growing EBIT at last year's rate of 14% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hang Lung Group will need earnings to service that debt. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Hang Lung Group produced sturdy free cash flow equating to 64% 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

Neither Hang Lung Group's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Hang Lung Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Hang Lung Group (1 shouldn't be ignored) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.