Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that LVGEM (China) Real Estate Investment Company Limited (HKG:95) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is LVGEM (China) Real Estate Investment's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2022 LVGEM (China) Real Estate Investment had debt of CN¥32.8b, up from CN¥30.6b in one year. However, because it has a cash reserve of CN¥2.74b, its net debt is less, at about CN¥30.0b.
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¥22.4b due within 12 months and liabilities of CN¥36.5b due beyond that. On the other hand, it had cash of CN¥2.74b and CN¥578.2m worth of receivables due within a year. So it has liabilities totalling CN¥55.6b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥5.83b 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. After all, LVGEM (China) Real Estate Investment would likely require a major re-capitalisation if it had to pay its creditors today.
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 0.61 times and a disturbingly high net debt to EBITDA ratio of 29.0 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 29% 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, LVGEM (China) Real Estate Investment saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
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 furthermore, its interest cover also fails to instill confidence. It looks to us like LVGEM (China) Real Estate Investment carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for LVGEM (China) Real Estate Investment (of which 2 are concerning!) you should know about.
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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LVGEM (China) Real Estate Investment
LVGEM (China) Real Estate Investment Company Limited, an investment holding company, engages in property development and investment businesses in the People’s Republic of China.
Mediocre balance sheet and slightly overvalued.