Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Yuzhou Properties Company Limited (HKG:1628) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Yuzhou Properties's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Yuzhou Properties had CN¥43.6b of debt, an increase on CN¥27.6b, over one year. However, because it has a cash reserve of CN¥27.2b, its net debt is less, at about CN¥16.5b.
How Healthy Is Yuzhou Properties's Balance Sheet?
The latest balance sheet data shows that Yuzhou Properties had liabilities of CN¥64.5b due within a year, and liabilities of CN¥29.1b falling due after that. On the other hand, it had cash of CN¥27.2b and CN¥31.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥66.4b.
This deficit casts a shadow over the CN¥14.0b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, Yuzhou Properties 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Yuzhou Properties has a debt to EBITDA ratio of 2.5, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k 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. Unfortunately, Yuzhou Properties 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Yuzhou Properties'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Yuzhou Properties produced sturdy free cash flow equating to 63% 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.
Mulling over Yuzhou Properties's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Yuzhou Properties'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 our hesitation about the stock, it would be good to know if Yuzhou Properties insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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