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. As with many other companies LVGEM (China) Real Estate Investment Company Limited (HKG:95) makes use of debt. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does LVGEM (China) Real Estate Investment Carry?
The chart below, which you can click on for greater detail, shows that LVGEM (China) Real Estate Investment had CN¥31.2b in debt in December 2021; about the same as the year before. However, because it has a cash reserve of CN¥3.91b, its net debt is less, at about CN¥27.3b.
A Look At LVGEM (China) Real Estate Investment's Liabilities
Zooming in on the latest balance sheet data, we can see that LVGEM (China) Real Estate Investment had liabilities of CN¥19.2b due within 12 months and liabilities of CN¥36.3b due beyond that. On the other hand, it had cash of CN¥3.91b and CN¥100.7m worth of receivables due within a year. So it has liabilities totalling CN¥51.5b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥5.11b 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. At the end of the day, LVGEM (China) Real Estate Investment 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). 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 0.90 times and a disturbingly high net debt to EBITDA ratio of 17.9 hit our confidence in LVGEM (China) Real Estate Investment like a one-two punch to the gut. The debt burden here is substantial. Even worse, LVGEM (China) Real Estate Investment saw its EBIT tank 29% 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. When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.
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. Looking at the most recent three years, LVGEM (China) Real Estate Investment recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
To be frank both LVGEM (China) Real Estate Investment's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that LVGEM (China) Real Estate Investment really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. For instance, we've identified 6 warning signs for LVGEM (China) Real Estate Investment (2 make us uncomfortable) you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.