Is Overseas Chinese Town (Asia) Holdings (HKG:3366) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Overseas Chinese Town (Asia) Holdings Limited (HKG:3366) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Overseas Chinese Town (Asia) Holdings

What Is Overseas Chinese Town (Asia) Holdings's Debt?

As you can see below, Overseas Chinese Town (Asia) Holdings had CN¥8.83b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥4.27b in cash, and so its net debt is CN¥4.55b.

How Healthy Is Overseas Chinese Town (Asia) Holdings' Balance Sheet?

We can see from the most recent balance sheet that Overseas Chinese Town (Asia) Holdings had liabilities of CN¥4.63b falling due within a year, and liabilities of CN¥7.56b due beyond that. Offsetting these obligations, it had cash of CN¥4.27b as well as receivables valued at CN¥1.06b due within 12 months. So it has liabilities totalling CN¥6.87b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥1.02b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Overseas Chinese Town (Asia) Holdings 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Overseas Chinese Town (Asia) Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (7.5), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. The debt burden here is substantial. The good news is that Overseas Chinese Town (Asia) Holdings grew its EBIT a smooth 55% 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 Overseas Chinese Town (Asia) Holdings 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, 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. Over the last three years, Overseas Chinese Town (Asia) Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Overseas Chinese Town (Asia) Holdings's conversion of EBIT to free cash flow 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 at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Overseas Chinese Town (Asia) Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Overseas Chinese Town (Asia) Holdings , 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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This article by Simply Wall St is general in nature. 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.
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