These 4 Measures Indicate That Longfor Group Holdings (HKG:960) Is Using Debt Extensively

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.' 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, Longfor Group Holdings Limited (HKG:960) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Longfor Group Holdings

What Is Longfor Group Holdings's Net Debt?

As you can see below, at the end of June 2021, Longfor Group Holdings had CN¥210.0b of debt, up from CN¥181.9b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥99.1b, its net debt is less, at about CN¥110.9b.

How Strong Is Longfor Group Holdings' Balance Sheet?

We can see from the most recent balance sheet that Longfor Group Holdings had liabilities of CN¥471.9b falling due within a year, and liabilities of CN¥200.9b due beyond that. On the other hand, it had cash of CN¥99.1b and CN¥107.9b worth of receivables due within a year. So it has liabilities totalling CN¥465.9b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥186.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Longfor Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Longfor Group Holdings's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Unfortunately, Longfor Group Holdings saw its EBIT slide 4.3% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Longfor Group Holdings's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Longfor Group Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

While Longfor Group Holdings's level of total liabilities has us nervous. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. When we consider all the factors discussed, it seems to us that Longfor Group Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Longfor Group Holdings (including 1 which can't be ignored) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.