Powerlong Real Estate Holdings (HKG:1238) Takes On Some Risk With Its Use Of Debt

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.' 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. We can see that Powerlong Real Estate Holdings Limited (HKG:1238) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Powerlong Real Estate Holdings

How Much Debt Does Powerlong Real Estate Holdings Carry?

As you can see below, at the end of December 2020, Powerlong Real Estate Holdings had CN¥66.6b of debt, up from CN¥55.3b a year ago. Click the image for more detail. However, it also had CN¥25.6b in cash, and so its net debt is CN¥40.9b.

How Strong Is Powerlong Real Estate Holdings' Balance Sheet?

According to the last reported balance sheet, Powerlong Real Estate Holdings had liabilities of CN¥89.3b due within 12 months, and liabilities of CN¥54.0b due beyond 12 months. On the other hand, it had cash of CN¥25.6b and CN¥7.55b worth of receivables due within a year. So it has liabilities totalling CN¥110.1b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥26.1b 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 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Powerlong Real Estate Holdings's net debt is 3.9 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 12.6 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. It is well worth noting that Powerlong Real Estate Holdings's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Powerlong Real Estate Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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 conversion of EBIT to free cash flow 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. Looking at the bigger picture, it seems clear to us that Powerlong Real Estate Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. To that end, you should learn about the 3 warning signs we've spotted with Powerlong Real Estate Holdings (including 2 which make us uncomfortable) .

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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