We Think Guorui Properties (HKG:2329) Is Taking Some Risk With Its 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.' 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. Importantly, Guorui Properties Limited (HKG:2329) does carry debt. But should shareholders be worried about its use of debt?

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. 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, 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.

Check out our latest analysis for Guorui Properties

How Much Debt Does Guorui Properties Carry?

You can click the graphic below for the historical numbers, but it shows that Guorui Properties had CN¥20.9b of debt in December 2021, down from CN¥23.5b, one year before. However, it also had CN¥556.9m in cash, and so its net debt is CN¥20.4b.

How Strong Is Guorui Properties' Balance Sheet?

The latest balance sheet data shows that Guorui Properties had liabilities of CN¥29.6b due within a year, and liabilities of CN¥16.0b falling due after that. On the other hand, it had cash of CN¥556.9m and CN¥6.24b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥38.8b.

This deficit casts a shadow over the CN¥775.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Guorui Properties would likely require a major re-capitalisation if it had to pay its creditors today.

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

Guorui Properties shareholders face the double whammy of a high net debt to EBITDA ratio (37.2), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that Guorui Properties grew its EBIT a smooth 96% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Guorui Properties will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Happily for any shareholders, Guorui Properties actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On the face of it, Guorui Properties's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Guorui Properties's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Guorui Properties (2 don't sit too well with us) you should be aware of.

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. 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.