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 can see that Country Garden Holdings Company Limited (HKG:2007) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.
What Is Country Garden Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Country Garden Holdings had CN¥332.4b of debt, an increase on CN¥294.7b, over one year. On the flip side, it has CN¥223.4b in cash leading to net debt of about CN¥109.1b.
How Strong Is Country Garden Holdings's Balance Sheet?
The latest balance sheet data shows that Country Garden Holdings had liabilities of CN¥1.31t due within a year, and liabilities of CN¥248.0b falling due after that. On the other hand, it had cash of CN¥223.4b and CN¥303.4b worth of receivables due within a year. So it has liabilities totalling CN¥1.03t more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥206.3b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Country Garden Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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). 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).
Country Garden Holdings has net debt of just 1.3 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hot shot teppanyaki chef handles cooking. In addition to that, we're happy to report that Country Garden Holdings has boosted its EBIT by 49%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Country Garden Holdings'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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Country Garden Holdings produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Country Garden Holdings's level of total liabilities was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Country Garden Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that Country Garden Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.