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.' 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 note that Hang Lung Properties Limited (HKG:101) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, 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.
How Much Debt Does Hang Lung Properties Carry?
The image below, which you can click on for greater detail, shows that at December 2021 Hang Lung Properties had debt of HK$46.3b, up from HK$38.5b in one year. However, it also had HK$8.39b in cash, and so its net debt is HK$37.9b.
How Strong Is Hang Lung Properties' Balance Sheet?
According to the last reported balance sheet, Hang Lung Properties had liabilities of HK$19.5b due within 12 months, and liabilities of HK$52.3b due beyond 12 months. On the other hand, it had cash of HK$8.39b and HK$3.19b worth of receivables due within a year. So it has liabilities totalling HK$60.3b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of HK$71.7b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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 Hang Lung Properties has a sky high EBITDA ratio of 5.5, implying high debt, but a strong interest coverage of 19.4. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. If Hang Lung Properties can keep growing EBIT at last year's rate of 15% 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 it is future earnings, more than anything, that will determine Hang Lung Properties's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Hang Lung Properties produced sturdy free cash flow equating to 61% 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.
On our analysis Hang Lung Properties's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. 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. Looking at all this data makes us feel a little cautious about Hang Lung Properties's debt levels. 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. 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. We've identified 1 warning sign with Hang Lung Properties , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.