Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Beijing Properties (Holdings) Limited (HKG:925) does carry debt. But is this debt a concern to shareholders?
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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Beijing Properties (Holdings)'s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Beijing Properties (Holdings) had debt of HK$8.25b, up from HK$7.83b in one year. On the flip side, it has HK$1.28b in cash leading to net debt of about HK$6.97b.
How Strong Is Beijing Properties (Holdings)'s Balance Sheet?
We can see from the most recent balance sheet that Beijing Properties (Holdings) had liabilities of HK$4.75b falling due within a year, and liabilities of HK$6.95b due beyond that. On the other hand, it had cash of HK$1.28b and HK$133.6m worth of receivables due within a year. So its liabilities total HK$10.3b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$1.68b 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, Beijing Properties (Holdings) 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.68 times and a disturbingly high net debt to EBITDA ratio of 18.7 hit our confidence in Beijing Properties (Holdings) like a one-two punch to the gut. The debt burden here is substantial. The silver lining is that Beijing Properties (Holdings) grew its EBIT by 108% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Beijing Properties (Holdings) 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Beijing Properties (Holdings) reported free cash flow worth 10% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Beijing Properties (Holdings)'s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Beijing Properties (Holdings)'s balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Over time, share prices tend to follow earnings per share, so if you're interested in Beijing Properties (Holdings), you may well want to click here to check an interactive graph of its earnings per share history.
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.
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