Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Powerlong Real Estate Holdings Limited (HKG:1238) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Powerlong Real Estate Holdings
How Much Debt Does Powerlong Real Estate Holdings Carry?
The image below, which you can click on for greater detail, shows that Powerlong Real Estate Holdings had debt of CN¥66.6b at the end of June 2022, a reduction from CN¥71.4b over a year. However, it also had CN¥14.9b in cash, and so its net debt is CN¥51.7b.
How Strong Is Powerlong Real Estate Holdings' Balance Sheet?
We can see from the most recent balance sheet that Powerlong Real Estate Holdings had liabilities of CN¥113.1b falling due within a year, and liabilities of CN¥62.9b due beyond that. Offsetting this, it had CN¥14.9b in cash and CN¥27.1b in receivables that were due within 12 months. So its liabilities total CN¥134.0b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥3.42b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Powerlong Real Estate Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
As it happens Powerlong Real Estate Holdings has a fairly concerning net debt to EBITDA ratio of 8.2 but very strong interest coverage of 11.6. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Powerlong Real Estate Holdings's EBIT fell a jaw-dropping 45% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Powerlong Real Estate Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Powerlong Real Estate Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, Powerlong Real Estate Holdings'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. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We think the chances that Powerlong Real Estate Holdings has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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 Powerlong Real Estate Holdings has 4 warning signs (and 1 which shouldn't be ignored) we think you should know about.
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.
About SEHK:1238
Powerlong Real Estate Holdings
An investment holding company, invests in, develops, operates, and manages commercial real estate projects in the People’s Republic of China.
Undervalued low.