The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Poly Property Group Co., Limited (HKG:119) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Poly Property Group's Net Debt?
As you can see below, at the end of December 2020, Poly Property Group had HK$86.9b of debt, up from HK$66.8b a year ago. Click the image for more detail. On the flip side, it has HK$43.0b in cash leading to net debt of about HK$44.0b.
A Look At Poly Property Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Poly Property Group had liabilities of HK$105.6b due within 12 months and liabilities of HK$60.7b due beyond that. On the other hand, it had cash of HK$43.0b and HK$21.1b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$102.3b.
This deficit casts a shadow over the HK$8.35b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Poly Property Group would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a net debt to EBITDA ratio of 5.7, it's fair to say Poly Property Group does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.0 times, suggesting it can responsibly service its obligations. Even worse, Poly Property Group saw its EBIT tank 25% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Poly Property Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. Considering the last three years, Poly Property Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Poly Property Group'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. And even its net debt to EBITDA fails to inspire much confidence. It looks to us like Poly Property Group carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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 instance, we've identified 3 warning signs for Poly Property Group (1 is potentially serious) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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