We Think Shui On Land (HKG:272) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Shui On Land Limited (HKG:272) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shui On Land

What Is Shui On Land's Net Debt?

As you can see below, Shui On Land had CN¥32.1b of debt at December 2021, down from CN¥38.3b a year prior. However, it also had CN¥17.3b in cash, and so its net debt is CN¥14.9b.

How Strong Is Shui On Land's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shui On Land had liabilities of CN¥34.1b due within 12 months and liabilities of CN¥30.6b due beyond that. Offsetting this, it had CN¥17.3b in cash and CN¥1.84b in receivables that were due within 12 months. So it has liabilities totalling CN¥45.6b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥7.66b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Shui On Land would likely require a major re-capitalisation if it had to pay its creditors today.

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

Shui On Land's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 6.4 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Shui On Land's EBIT launched higher than Elon Musk, gaining a whopping 404% on 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 Shui On Land 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Shui On Land produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither Shui On Land's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Shui On Land's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 2 warning signs for Shui On Land (1 is a bit concerning) 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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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.