We Think Redco Properties Group (HKG:1622) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Redco Properties Group Limited (HKG:1622) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Redco Properties Group

What Is Redco Properties Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Redco Properties Group had CN¥26.3b of debt, an increase on CN¥18.1b, over one year. However, because it has a cash reserve of CN¥9.65b, its net debt is less, at about CN¥16.7b.

How Strong Is Redco Properties Group's Balance Sheet?

The latest balance sheet data shows that Redco Properties Group had liabilities of CN¥57.7b due within a year, and liabilities of CN¥15.4b falling due after that. On the other hand, it had cash of CN¥9.65b and CN¥9.54b worth of receivables due within a year. So its liabilities total CN¥53.8b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥7.87b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Redco Properties Group would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Strangely Redco Properties Group has a sky high EBITDA ratio of 8.4, implying high debt, but a strong interest coverage of 83.1. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Sadly, Redco Properties Group's EBIT actually dropped 3.2% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But it is Redco Properties Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last three years, Redco Properties Group's free cash flow amounted to 40% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Redco Properties Group's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Redco Properties Group to be really rather risky, as a result of its balance sheet health. 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. For example - Redco Properties Group has 1 warning sign we think you should be aware of.

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. 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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