David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Skyfame Realty (Holdings) Limited (HKG:59) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Skyfame Realty (Holdings)
What Is Skyfame Realty (Holdings)'s Net Debt?
As you can see below, at the end of December 2020, Skyfame Realty (Holdings) had CN¥8.69b of debt, up from CN¥6.26b a year ago. Click the image for more detail. However, it does have CN¥2.74b in cash offsetting this, leading to net debt of about CN¥5.95b.
How Strong Is Skyfame Realty (Holdings)'s Balance Sheet?
We can see from the most recent balance sheet that Skyfame Realty (Holdings) had liabilities of CN¥17.5b falling due within a year, and liabilities of CN¥6.74b due beyond that. Offsetting this, it had CN¥2.74b in cash and CN¥2.28b in receivables that were due within 12 months. So it has liabilities totalling CN¥19.2b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥6.59b 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. At the end of the day, Skyfame Realty (Holdings) would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Skyfame Realty (Holdings) has a debt to EBITDA ratio of 4.1, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. One way Skyfame Realty (Holdings) could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Skyfame Realty (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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Skyfame Realty (Holdings)'s free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
Mulling over Skyfame Realty (Holdings)'s attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Skyfame Realty (Holdings)'s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 example Skyfame Realty (Holdings) has 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.
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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About SEHK:59
Skyfame Realty (Holdings)
An investment holding company, engages in the property development, investment, and management activities in the People’s Republic of China.
Good value with imperfect balance sheet.