These 4 Measures Indicate That Hong Pu Real Estate Development (TPE:2536) Is Using Debt Extensively

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, Hong Pu Real Estate Development Co., Ltd. (TPE:2536) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hong Pu Real Estate Development

How Much Debt Does Hong Pu Real Estate Development Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Hong Pu Real Estate Development had NT$9.35b of debt, an increase on NT$7.23b, over one year. However, it does have NT$1.05b in cash offsetting this, leading to net debt of about NT$8.30b.

How Healthy Is Hong Pu Real Estate Development's Balance Sheet?

The latest balance sheet data shows that Hong Pu Real Estate Development had liabilities of NT$10.5b due within a year, and liabilities of NT$10.1m falling due after that. Offsetting these obligations, it had cash of NT$1.05b as well as receivables valued at NT$72.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$9.42b.

When you consider that this deficiency exceeds the company's NT$7.49b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Hong Pu Real Estate Development's debt to EBITDA ratio of 10.7 suggests a heavy debt load, its interest coverage of 8.5 implies it services that debt with ease. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. We note that Hong Pu Real Estate Development grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hong Pu Real Estate Development will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hong Pu Real Estate Development burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Hong Pu Real Estate Development's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Hong Pu Real Estate Development has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Hong Pu Real Estate Development (at least 2 which can't be ignored) , and understanding them should be part of your investment process.

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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