These 4 Measures Indicate That Hon Kwok Land Investment Company (HKG:160) Is Using Debt In A Risky Way

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Hon Kwok Land Investment Company, Limited (HKG:160) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Hon Kwok Land Investment Company

What Is Hon Kwok Land Investment Company's Debt?

As you can see below, at the end of September 2020, Hon Kwok Land Investment Company had HK$5.76b of debt, up from HK$4.94b a year ago. Click the image for more detail. However, it also had HK$1.93b in cash, and so its net debt is HK$3.83b.

How Strong Is Hon Kwok Land Investment Company's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hon Kwok Land Investment Company had liabilities of HK$3.32b due within 12 months and liabilities of HK$4.85b due beyond that. On the other hand, it had cash of HK$1.93b and HK$20.6m worth of receivables due within a year. So it has liabilities totalling HK$6.22b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$1.89b 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 13.6 hit our confidence in Hon Kwok Land Investment Company like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a slightly more positive note, Hon Kwok Land Investment Company grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Hon Kwok Land Investment Company 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.

Our View

To be frank both Hon Kwok Land Investment Company's conversion of EBIT to free cash flow 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 growing its EBIT; that's encouraging. Taking into account all the aforementioned factors, it looks like Hon Kwok Land Investment Company has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Hon Kwok Land Investment Company you should be aware of, and 2 of them shouldn't be ignored.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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