Is China Merchants Land (HKG:978) Using Too Much Debt?

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. We note that China Merchants Land Limited (HKG:978) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for China Merchants Land

How Much Debt Does China Merchants Land Carry?

As you can see below, China Merchants Land had CN¥23.0b of debt at June 2020, down from CN¥24.4b a year prior. However, it also had CN¥8.47b in cash, and so its net debt is CN¥14.6b.

How Strong Is China Merchants Land's Balance Sheet?

According to the last reported balance sheet, China Merchants Land had liabilities of CN¥51.5b due within 12 months, and liabilities of CN¥14.0b due beyond 12 months. Offsetting these obligations, it had cash of CN¥8.47b as well as receivables valued at CN¥18.8b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥38.2b.

The deficiency here weighs heavily on the CN¥4.71b 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, China Merchants Land would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Merchants Land's net debt is 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 11.6 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that China Merchants Land's EBIT shot up like bamboo after rain, gaining 84% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is China Merchants Land's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Looking at the most recent three years, China Merchants Land recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While China Merchants Land's level of total liabilities has us nervous. To wit both its EBIT growth rate and interest cover were encouraging signs. When we consider all the factors discussed, it seems to us that China Merchants Land is taking some risks with its use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with China Merchants Land (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.

If you decide to trade China Merchants Land, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.