Hysan Development (HKG:14) Has A Somewhat Strained Balance Sheet

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hysan Development Company Limited (HKG:14) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hysan Development

What Is Hysan Development's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Hysan Development had debt of HK$26.6b, up from HK$19.5b in one year. However, it also had HK$5.92b in cash, and so its net debt is HK$20.7b.

How Healthy Is Hysan Development's Balance Sheet?

We can see from the most recent balance sheet that Hysan Development had liabilities of HK$1.84b falling due within a year, and liabilities of HK$27.6b due beyond that. Offsetting this, it had HK$5.92b in cash and HK$313.0m in receivables that were due within 12 months. So its liabilities total HK$23.2b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$25.9b, so it does suggest shareholders should keep an eye on Hysan Development's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Hysan Development's net debt to EBITDA ratio is 6.7 which suggests rather high debt levels, but its interest cover of 8.4 times suggests the debt is easily serviced. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. Unfortunately, Hysan Development saw its EBIT slide 6.1% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hysan 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hysan Development produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Hysan Development's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its conversion of EBIT to free cash flow was re-invigorating. When we consider all the factors discussed, it seems to us that Hysan Development is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Hysan Development that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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