Here's Why Tern Properties (HKG:277) Can Afford Some 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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Tern Properties Company Limited (HKG:277) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Tern Properties

What Is Tern Properties's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Tern Properties had HK$250.2m of debt in September 2020, down from HK$272.5m, one year before. However, because it has a cash reserve of HK$176.3m, its net debt is less, at about HK$73.9m.

How Healthy Is Tern Properties's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tern Properties had liabilities of HK$37.7m due within 12 months and liabilities of HK$276.5m due beyond that. Offsetting this, it had HK$176.3m in cash and HK$16.6m in receivables that were due within 12 months. So its liabilities total HK$121.4m more than the combination of its cash and short-term receivables.

Since publicly traded Tern Properties shares are worth a total of HK$888.5m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tern Properties's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Over 12 months, Tern Properties made a loss at the EBIT level, and saw its revenue drop to HK$14m, which is a fall of 82%. To be frank that doesn't bode well.

Caveat Emptor

While Tern Properties's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost HK$11m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. We would feel better if it turned its trailing twelve month loss of HK$327m into a profit. So we do think this stock is quite 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Tern Properties (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

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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