We Think Vanke Overseas Investment Holding (HKG:1036) Can Stay On Top Of Its Debt

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. Importantly, Vanke Overseas Investment Holding Company Limited (HKG:1036) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Vanke Overseas Investment Holding

What Is Vanke Overseas Investment Holding's Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Vanke Overseas Investment Holding had debt of HK$1.24b, up from HK$1.12b in one year. On the flip side, it has HK$659.7m in cash leading to net debt of about HK$577.1m.

How Strong Is Vanke Overseas Investment Holding's Balance Sheet?

According to the last reported balance sheet, Vanke Overseas Investment Holding had liabilities of HK$1.07b due within 12 months, and liabilities of HK$556.0m due beyond 12 months. Offsetting these obligations, it had cash of HK$659.7m as well as receivables valued at HK$72.3m due within 12 months. So it has liabilities totalling HK$891.2m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$954.3m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Vanke Overseas Investment Holding's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 11.6 times its interest expense, implies the debt load is as light as a peacock feather. One way Vanke Overseas Investment Holding could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Vanke Overseas Investment Holding will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Vanke Overseas Investment Holding recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Vanke Overseas Investment Holding was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Vanke Overseas Investment Holding'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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Vanke Overseas Investment Holding you should know about.

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.
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