Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, LVGEM (China) Real Estate Investment Company Limited (HKG:95) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does LVGEM (China) Real Estate Investment Carry?
As you can see below, at the end of December 2020, LVGEM (China) Real Estate Investment had CN¥30.7b of debt, up from CN¥26.0b a year ago. Click the image for more detail. However, it also had CN¥5.43b in cash, and so its net debt is CN¥25.2b.
How Strong Is LVGEM (China) Real Estate Investment's Balance Sheet?
The latest balance sheet data shows that LVGEM (China) Real Estate Investment had liabilities of CN¥15.9b due within a year, and liabilities of CN¥30.5b falling due after that. On the other hand, it had cash of CN¥5.43b and CN¥120.6m worth of receivables due within a year. So its liabilities total CN¥40.8b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥9.17b 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, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 12.0 hit our confidence in LVGEM (China) Real Estate Investment like a one-two punch to the gut. The debt burden here is substantial. Worse, LVGEM (China) Real Estate Investment's EBIT was down 46% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine LVGEM (China) Real Estate Investment's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. Looking at the most recent three years, LVGEM (China) Real Estate Investment recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
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. Taking into account all the aforementioned factors, it looks like LVGEM (China) Real Estate Investment has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example LVGEM (China) Real Estate Investment has 3 warning signs (and 2 which are a bit concerning) we think you should know about.
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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