Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Kerry Properties Limited (HKG:683) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
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What Is Kerry Properties's Debt?
As you can see below, Kerry Properties had HK$39.9b of debt at December 2021, down from HK$47.5b a year prior. However, it also had HK$16.5b in cash, and so its net debt is HK$23.4b.
How Healthy Is Kerry Properties' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kerry Properties had liabilities of HK$22.4b due within 12 months and liabilities of HK$45.3b due beyond that. Offsetting this, it had HK$16.5b in cash and HK$3.16b in receivables that were due within 12 months. So it has liabilities totalling HK$48.1b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$31.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Kerry Properties 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Kerry Properties's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its commanding EBIT of 17.0 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Kerry Properties grew its EBIT by 41% over the last twelve months, and that growth will make it easier to handle its debt. 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 Kerry Properties can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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 most recent three years, Kerry Properties recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Kerry Properties's interest cover was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Kerry Properties is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that Kerry Properties is showing 1 warning sign in our investment analysis , 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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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.
About SEHK:683
Kerry Properties
An investment holding company, engages in the development, investment, management, and trading of properties in Hong Kong, Mainland China, and the Asia Pacific region.
Undervalued established dividend payer.