David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Hang Lung Properties Limited (HKG:101) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Hang Lung Properties Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Hang Lung Properties had HK$41.7b of debt, an increase on HK$33.2b, over one year. However, it also had HK$2.92b in cash, and so its net debt is HK$38.7b.
A Look At Hang Lung Properties' Liabilities
According to the last reported balance sheet, Hang Lung Properties had liabilities of HK$18.9b due within 12 months, and liabilities of HK$46.7b due beyond 12 months. Offsetting these obligations, it had cash of HK$2.92b as well as receivables valued at HK$2.77b due within 12 months. So its liabilities total HK$59.9b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of HK$69.9b, so it does suggest shareholders should keep an eye on Hang Lung Properties' 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.
As it happens Hang Lung Properties has a fairly concerning net debt to EBITDA ratio of 5.9 but very strong interest coverage of 30.7. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. One way Hang Lung Properties could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. 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 Hang Lung Properties 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Hang Lung Properties recorded free cash flow worth 62% 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.
On our analysis Hang Lung Properties's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. To be specific, it seems about as good at managing its debt, based on its EBITDA, as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Hang Lung Properties's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 - Hang Lung Properties has 2 warning signs we think you should be aware of.
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.