Is Wharf Real Estate Investment (HKG:1997) A Risky Investment?

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.' 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. We note that Wharf Real Estate Investment Company Limited (HKG:1997) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Wharf Real Estate Investment

What Is Wharf Real Estate Investment's Debt?

As you can see below, Wharf Real Estate Investment had HK$51.1b of debt at June 2022, down from HK$53.8b a year prior. On the flip side, it has HK$1.80b in cash leading to net debt of about HK$49.3b.

How Strong Is Wharf Real Estate Investment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Wharf Real Estate Investment had liabilities of HK$13.4b due within 12 months and liabilities of HK$48.8b due beyond that. Offsetting these obligations, it had cash of HK$1.80b as well as receivables valued at HK$1.53b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$58.9b.

While this might seem like a lot, it is not so bad since Wharf Real Estate Investment has a huge market capitalization of HK$112.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Wharf Real Estate Investment's net debt to EBITDA ratio is 5.2 which suggests rather high debt levels, but its interest cover of 10.0 times suggests the debt is easily serviced. Our best guess is that the company does indeed have significant debt obligations. Sadly, Wharf Real Estate Investment's EBIT actually dropped 3.7% 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into 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

Wharf Real Estate Investment's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. But truth be told its net debt to EBITDA had us nibbling our nails. Looking at all this data makes us feel a little cautious about Wharf Real Estate Investment's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Wharf Real Estate Investment 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.