Is Sunac China Holdings (HKG:1918) Using Too Much Debt?

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.' 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. Importantly, Sunac China Holdings Limited (HKG:1918) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sunac China Holdings

What Is Sunac China Holdings's Debt?

The image below, which you can click on for greater detail, shows that Sunac China Holdings had debt of CN¥303.4b at the end of December 2020, a reduction from CN¥322.3b over a year. However, because it has a cash reserve of CN¥102.2b, its net debt is less, at about CN¥201.3b.

How Strong Is Sunac China Holdings' Balance Sheet?

According to the last reported balance sheet, Sunac China Holdings had liabilities of CN¥683.9b due within 12 months, and liabilities of CN¥246.7b due beyond 12 months. On the other hand, it had cash of CN¥102.2b and CN¥94.3b worth of receivables due within a year. So its liabilities total CN¥734.1b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥119.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Sunac China Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Sunac China Holdings has a sky high EBITDA ratio of 5.8, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. One way Sunac China Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 18%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sunac China Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sunac China Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We feel some trepidation about Sunac China Holdings's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. We think that Sunac China Holdings's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Sunac China Holdings you should know about.

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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