The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. As with many other companies Star Properties Group (Cayman Islands) Limited (HKG:1560) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Star Properties Group (Cayman Islands) Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 Star Properties Group (Cayman Islands) had HK$2.62b of debt, an increase on HK$2.36b, over one year. On the flip side, it has HK$62.7m in cash leading to net debt of about HK$2.56b.
A Look At Star Properties Group (Cayman Islands)’s Liabilities
According to the last reported balance sheet, Star Properties Group (Cayman Islands) had liabilities of HK$2.78b due within 12 months, and liabilities of HK$177.0k due beyond 12 months. Offsetting these obligations, it had cash of HK$62.7m as well as receivables valued at HK$25.7m due within 12 months. So its liabilities total HK$2.69b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the HK$282.3m 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. After all, Star Properties Group (Cayman Islands) 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 94.2 hit our confidence in Star Properties Group (Cayman Islands) like a one-two punch to the gut. The debt burden here is substantial. Even worse, Star Properties Group (Cayman Islands) saw its EBIT tank 89% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Star Properties Group (Cayman Islands) will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Star Properties Group (Cayman Islands) 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.
To be frank both Star Properties Group (Cayman Islands)’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering everything we’ve mentioned above, it’s fair to say that Star Properties Group (Cayman Islands) is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Be aware that Star Properties Group (Cayman Islands) is showing 5 warning signs in our investment analysis , and 1 of those makes us a bit 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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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