Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. We note that Hang Lung Group Limited (HKG:10) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Hang Lung Group's Debt?
As you can see below, at the end of June 2019, Hang Lung Group had HK$34.1b of debt, up from HK$29.0b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$4.22b, its net debt is less, at about HK$29.9b.
A Look At Hang Lung Group's Liabilities
We can see from the most recent balance sheet that Hang Lung Group had liabilities of HK$10.5b falling due within a year, and liabilities of HK$40.5b due beyond that. Offsetting this, it had HK$4.22b in cash and HK$2.04b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$44.8b.
This deficit casts a shadow over the HK$26.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Hang Lung Group would probably need a major re-capitalization if its creditors were to demand repayment.
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).
Hang Lung Group's net debt is 4.7 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 23.2 times its interest expense, implying the company isn't really paying full freight on that debt. Even if not sustainable, that is a good sign. The bad news is that Hang Lung Group saw its EBIT decline by 12% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But it is Hang Lung Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Hang Lung Group recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
We'd go so far as to say Hang Lung Group's level of total liabilities was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Hang Lung Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Given Hang Lung Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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