Powerlong Real Estate Holdings (HKG:1238) Seems To Be Using A Lot Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Powerlong Real Estate Holdings Limited (HKG:1238) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Powerlong Real Estate Holdings

What Is Powerlong Real Estate Holdings's Debt?

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 does have CN¥14.9b in cash offsetting this, leading to net debt of about CN¥51.7b.

How Healthy Is Powerlong Real Estate Holdings' Balance Sheet?

The latest balance sheet data shows that Powerlong Real Estate Holdings had liabilities of CN¥113.1b due within a year, and liabilities of CN¥62.9b falling due after that. On the other hand, it had cash of CN¥14.9b and CN¥17.5b worth of receivables due within a year. So its liabilities total CN¥143.6b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥7.32b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Powerlong Real Estate Holdings 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). 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 44% 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Powerlong Real Estate Holdings recorded negative free cash flow, in total. 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.

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 at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think Powerlong Real Estate Holdings has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Powerlong Real Estate Holdings has 4 warning signs (and 1 which shouldn't be ignored) 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.