Is Swire Pacific (HKG:19) Using Too Much Debt?

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.' 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 Swire Pacific Limited (HKG:19) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Swire Pacific

What Is Swire Pacific's Debt?

The chart below, which you can click on for greater detail, shows that Swire Pacific had HK$69.0b in debt in December 2020; about the same as the year before. However, it also had HK$29.3b in cash, and so its net debt is HK$39.8b.

How Healthy Is Swire Pacific's Balance Sheet?

The latest balance sheet data shows that Swire Pacific had liabilities of HK$34.4b due within a year, and liabilities of HK$79.5b falling due after that. Offsetting these obligations, it had cash of HK$29.3b as well as receivables valued at HK$8.42b due within 12 months. So it has liabilities totalling HK$76.3b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$76.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Swire Pacific's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 4.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, Swire Pacific's EBIT was down 32% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Swire Pacific's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Swire Pacific recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

We'd go so far as to say Swire Pacific's EBIT growth rate was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Swire Pacific stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Case in point: We've spotted 1 warning sign for Swire Pacific you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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