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.' 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. Importantly, China Overseas Land & Investment Limited (HKG:688) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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, 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.
What Is China Overseas Land & Investment's Net Debt?
As you can see below, at the end of December 2020, China Overseas Land & Investment had CN¥213.0b of debt, up from CN¥203.4b a year ago. Click the image for more detail. However, it does have CN¥110.5b in cash offsetting this, leading to net debt of about CN¥102.5b.
How Healthy Is China Overseas Land & Investment's Balance Sheet?
The latest balance sheet data shows that China Overseas Land & Investment had liabilities of CN¥304.0b due within a year, and liabilities of CN¥191.3b falling due after that. Offsetting this, it had CN¥110.5b in cash and CN¥30.6b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥354.2b.
This deficit casts a shadow over the CN¥201.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, China Overseas Land & Investment would probably need a major re-capitalization if its creditors were to demand repayment.
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.
We'd say that China Overseas Land & Investment's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its strong interest cover of 63.4 times, makes us even more comfortable. One way China Overseas Land & Investment could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Overseas Land & Investment 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, China Overseas Land & Investment created free cash flow amounting to 17% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over China Overseas Land & Investment's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that China Overseas Land & Investment'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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for China Overseas Land & Investment you should be aware of, and 1 of them is a bit concerning.
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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