Is Wharf Real Estate Investment (HKG:1997) Using Too Much Debt?

Simply Wall St
March 18, 2022
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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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Wharf Real Estate Investment Company Limited (HKG:1997) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt 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 Wharf Real Estate Investment had HK$50.0b of debt in December 2021, down from HK$54.8b, one year before. However, because it has a cash reserve of HK$2.95b, its net debt is less, at about HK$47.0b.

SEHK:1997 Debt to Equity History March 18th 2022

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

According to the last reported balance sheet, Wharf Real Estate Investment had liabilities of HK$13.0b due within 12 months, and liabilities of HK$48.4b due beyond 12 months. On the other hand, it had cash of HK$2.95b and HK$1.16b worth of receivables due within a year. So its liabilities total HK$57.3b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Wharf Real Estate Investment is worth a massive HK$118.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Wharf Real Estate Investment has a fairly concerning net debt to EBITDA ratio of 5.0 but very strong interest coverage of 13.7. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Unfortunately, Wharf Real Estate Investment saw its EBIT slide 9.1% in the last twelve months. 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 ultimately the future profitability of the business will decide if Wharf Real Estate Investment 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wharf Real Estate Investment produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Wharf Real Estate Investment's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. But truth be told its net debt to EBITDA had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Wharf Real Estate Investment's use of debt. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Wharf Real Estate Investment that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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