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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Sun Hung Kai Properties Limited (HKG:16) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Sun Hung Kai Properties
What Is Sun Hung Kai Properties's Net Debt?
The chart below, which you can click on for greater detail, shows that Sun Hung Kai Properties had HK$116.9b in debt in June 2021; about the same as the year before. However, it also had HK$23.2b in cash, and so its net debt is HK$93.8b.
How Strong Is Sun Hung Kai Properties' Balance Sheet?
We can see from the most recent balance sheet that Sun Hung Kai Properties had liabilities of HK$73.2b falling due within a year, and liabilities of HK$123.6b due beyond that. Offsetting this, it had HK$23.2b in cash and HK$13.3b in receivables that were due within 12 months. So its liabilities total HK$160.4b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Sun Hung Kai Properties is worth a massive HK$292.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
Sun Hung Kai Properties's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its commanding EBIT of 20.7 times its interest expense, implies the debt load is as light as a peacock feather. We saw Sun Hung Kai Properties grow its EBIT by 4.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to 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 Sun Hung Kai Properties'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Sun Hung Kai Properties recorded free cash flow worth 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
On our analysis Sun Hung Kai Properties's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Sun Hung Kai Properties is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Sun Hung Kai Properties insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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About SEHK:16
Sun Hung Kai Properties
Develops and invests in properties for sale and rent in Hong Kong, Mainland China, and internationally.
Good value with adequate balance sheet and pays a dividend.