Here's Why LVGEM (China) Real Estate Investment (HKG:95) Is Weighed Down By Its Debt Load

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that LVGEM (China) Real Estate Investment Company Limited (HKG:95) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for LVGEM (China) Real Estate Investment

What Is LVGEM (China) Real Estate Investment's Net Debt?

As you can see below, at the end of June 2021, LVGEM (China) Real Estate Investment had CN¥30.6b of debt, up from CN¥29.4b a year ago. Click the image for more detail. On the flip side, it has CN¥5.03b in cash leading to net debt of about CN¥25.6b.

A Look At LVGEM (China) Real Estate Investment's Liabilities

The latest balance sheet data shows that LVGEM (China) Real Estate Investment had liabilities of CN¥16.8b due within a year, and liabilities of CN¥32.6b falling due after that. Offsetting this, it had CN¥5.03b in cash and CN¥370.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥44.0b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥6.58b 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, LVGEM (China) Real Estate 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).

Weak interest cover of 0.87 times and a disturbingly high net debt to EBITDA ratio of 18.0 hit our confidence in LVGEM (China) Real Estate Investment like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, LVGEM (China) Real Estate Investment saw its EBIT tank 55% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 LVGEM (China) Real Estate Investment can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, LVGEM (China) Real Estate Investment's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, LVGEM (China) Real Estate Investment's EBIT growth rate 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 its conversion of EBIT to free cash flow is not so bad. Considering all the factors previously mentioned, we think that LVGEM (China) Real Estate Investment really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with LVGEM (China) Real Estate Investment (at least 2 which are a bit unpleasant) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.