Gemdale Properties and Investment (HKG:535) Has A Somewhat Strained Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Gemdale Properties and Investment Corporation Limited (HKG:535) makes use of debt. But the more important question is: how much risk is that debt creating?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Gemdale Properties and Investment

What Is Gemdale Properties and Investment's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Gemdale Properties and Investment had debt of CN¥18.3b, up from CN¥10.3b in one year. On the flip side, it has CN¥7.15b in cash leading to net debt of about CN¥11.2b.

How Healthy Is Gemdale Properties and Investment's Balance Sheet?

We can see from the most recent balance sheet that Gemdale Properties and Investment had liabilities of CN¥24.3b falling due within a year, and liabilities of CN¥19.0b due beyond that. Offsetting this, it had CN¥7.15b in cash and CN¥5.15b in receivables that were due within 12 months. So its liabilities total CN¥31.0b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥16.4b 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 definitely think shareholders need to watch this one closely. After all, Gemdale Properties and Investment 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). 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).

Gemdale Properties and Investment's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 26.6 times, makes us even more comfortable. Gemdale Properties and Investment grew its EBIT by 4.5% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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 Gemdale Properties and Investment will need earnings to service that debt. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Gemdale Properties and Investment recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

We feel some trepidation about Gemdale Properties and Investment's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. We think that Gemdale Properties and Investment'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Gemdale Properties and Investment .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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