Does Wharf Real Estate Investment (HKG:1997) Have A Healthy Balance Sheet?

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. Importantly, Wharf Real Estate Investment Company Limited (HKG:1997) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Wharf Real Estate Investment

How Much Debt Does Wharf Real Estate Investment Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Wharf Real Estate Investment had HK$54.8b of debt, an increase on HK$45.6b, over one year. On the flip side, it has HK$2.26b in cash leading to net debt of about HK$52.5b.

A Look At Wharf Real Estate Investment's Liabilities

We can see from the most recent balance sheet that Wharf Real Estate Investment had liabilities of HK$17.1b falling due within a year, and liabilities of HK$51.4b due beyond that. On the other hand, it had cash of HK$2.26b and HK$1.68b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$64.6b.

Wharf Real Estate Investment has a very large market capitalization of HK$131.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Wharf Real Estate Investment's net debt to EBITDA ratio is 5.1 which suggests rather high debt levels, but its interest cover of 7.5 times suggests the debt is easily serviced. Our best guess is that the company does indeed have significant debt obligations. Shareholders should be aware that Wharf Real Estate Investment's EBIT was down 21% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Wharf Real Estate Investment'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Wharf Real Estate Investment recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

While Wharf Real Estate Investment's net debt to EBITDA makes us cautious about it, its track record of (not) growing its EBIT is no better. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Wharf Real Estate Investment is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. We've identified 1 warning sign with Wharf Real Estate Investment , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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