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

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.' 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 Longfor Group Holdings Limited (HKG:960) does have debt on its balance sheet. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Longfor Group Holdings

What Is Longfor Group Holdings's Net Debt?

As you can see below, at the end of December 2021, Longfor Group Holdings had CN¥212.4b of debt, up from CN¥182.9b a year ago. Click the image for more detail. However, it also had CN¥88.2b in cash, and so its net debt is CN¥124.2b.

How Strong Is Longfor Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Longfor Group Holdings had liabilities of CN¥446.5b due within 12 months and liabilities of CN¥207.2b due beyond that. Offsetting these obligations, it had cash of CN¥88.2b as well as receivables valued at CN¥141.3b due within 12 months. So it has liabilities totalling CN¥424.3b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥192.2b 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, 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). 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).

Longfor Group Holdings's net debt is 3.1 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 43.2 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Sadly, Longfor Group Holdings's EBIT actually dropped 3.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Longfor Group Holdings 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, 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. During the last three years, Longfor Group Holdings produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We feel some trepidation about Longfor Group Holdings's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. Taking the abovementioned factors together we do think Longfor Group Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 4 warning signs for Longfor Group Holdings (1 is potentially serious!) that you should be aware of before investing here.

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.