Henderson Land Development (HKG:12) Use Of Debt Could Be Considered Risky

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Henderson Land Development Company Limited (HKG:12) makes use of debt. But should shareholders be worried about its use of debt?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Henderson Land Development

How Much Debt Does Henderson Land Development Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Henderson Land Development had HK$157.5b of debt, an increase on HK$102.3b, over one year. However, it does have HK$14.0b in cash offsetting this, leading to net debt of about HK$143.5b.

How Healthy Is Henderson Land Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Henderson Land Development had liabilities of HK$63.3b due within 12 months and liabilities of HK$134.5b due beyond that. Offsetting this, it had HK$14.0b in cash and HK$9.76b in receivables that were due within 12 months. So its liabilities total HK$174.0b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's huge HK$127.3b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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 Henderson Land Development has a sky high EBITDA ratio of 15.5, implying high debt, but a strong interest coverage of 49.2. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. The bad news is that Henderson Land Development saw its EBIT decline by 19% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Henderson Land Development'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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Henderson Land Development's free cash flow amounted to 48% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Henderson Land Development's EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, it seems to us that Henderson Land Development's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 example Henderson Land Development has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.