These 4 Measures Indicate That Powerlong Real Estate Holdings (HKG:1238) Is Using Debt Extensively

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. 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?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Powerlong Real Estate Holdings

How Much Debt Does Powerlong Real Estate Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Powerlong Real Estate Holdings had CN¥66.6b of debt, an increase on CN¥55.3b, over one year. However, it does have CN¥25.6b in cash offsetting this, leading to net debt of about CN¥40.9b.

A Look At Powerlong Real Estate Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Powerlong Real Estate Holdings had liabilities of CN¥89.3b due within 12 months and liabilities of CN¥54.0b due beyond that. Offsetting these obligations, it had cash of CN¥25.6b as well as receivables valued at CN¥18.6b due within 12 months. So it has liabilities totalling CN¥99.1b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥22.1b 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'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

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. Importantly, Powerlong Real Estate Holdings grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 reported free cash flow worth 17% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Powerlong Real Estate Holdings's level of total liabilities was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Powerlong Real Estate Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Powerlong Real Estate Holdings (of which 1 is concerning!) you should know about.

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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