Is Sun Hung Kai Properties (HKG:16) A Risky Investment?

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.' 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 note that Sun Hung Kai Properties Limited (HKG:16) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Sun Hung Kai Properties

What Is Sun Hung Kai Properties's Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Sun Hung Kai Properties had debt of HK$122.9b, up from HK$107.5b in one year. However, because it has a cash reserve of HK$18.7b, its net debt is less, at about HK$104.1b.

How Healthy Is Sun Hung Kai Properties' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sun Hung Kai Properties had liabilities of HK$73.4b due within 12 months and liabilities of HK$129.3b due beyond that. Offsetting this, it had HK$18.7b in cash and HK$15.8b in receivables that were due within 12 months. So it has liabilities totalling HK$168.2b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of HK$277.5b. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sun Hung Kai Properties's net debt is 3.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 19.5 is very high, suggesting that the interest expense on the debt is currently quite low. The bad news is that Sun Hung Kai Properties saw its EBIT decline by 19% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sun Hung Kai Properties 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sun Hung Kai Properties produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Neither Sun Hung Kai Properties's ability to grow its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Sun Hung Kai Properties's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Sun Hung Kai Properties is showing 1 warning sign in our investment analysis , 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.