Hon Kwok Land Investment Company (HKG:160) Takes On Some Risk With Its Use Of Debt

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.' 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. We note that Hon Kwok Land Investment Company, Limited (HKG:160) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hon Kwok Land Investment Company

What Is Hon Kwok Land Investment Company's Net Debt?

The chart below, which you can click on for greater detail, shows that Hon Kwok Land Investment Company had HK$5.53b in debt in March 2022; about the same as the year before. However, it does have HK$1.89b in cash offsetting this, leading to net debt of about HK$3.63b.

A Look At Hon Kwok Land Investment Company's Liabilities

According to the last reported balance sheet, Hon Kwok Land Investment Company had liabilities of HK$4.15b due within 12 months, and liabilities of HK$3.87b due beyond 12 months. On the other hand, it had cash of HK$1.89b and HK$218.9m worth of receivables due within a year. So it has liabilities totalling HK$5.91b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$1.58b 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 definitely think shareholders need to watch this one closely. At the end of the day, Hon Kwok Land Investment Company would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

Hon Kwok Land Investment Company has a rather high debt to EBITDA ratio of 8.6 which suggests a meaningful debt load. However, its interest coverage of 2.9 is reasonably strong, which is a good sign. More concerning, Hon Kwok Land Investment Company saw its EBIT drop by 8.3% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hon Kwok Land Investment Company's earnings that will influence how the balance sheet holds up in the future. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Hon Kwok Land Investment Company generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

To be frank both Hon Kwok Land Investment Company's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Hon Kwok Land Investment Company's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Case in point: We've spotted 3 warning signs for Hon Kwok Land Investment Company you should be aware of, and 1 of them is a bit concerning.

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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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.