Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Hang Lung Properties Limited (HKG:101) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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.
How Much Debt Does Hang Lung Properties Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Hang Lung Properties had HK$32.2b of debt, an increase on HK$25.9b, over one year. However, it also had HK$3.06b in cash, and so its net debt is HK$29.2b.
How Strong Is Hang Lung Properties's Balance Sheet?
According to the last reported balance sheet, Hang Lung Properties had liabilities of HK$9.99b due within 12 months, and liabilities of HK$37.7b due beyond 12 months. On the other hand, it had cash of HK$3.06b and HK$2.03b worth of receivables due within a year. So it has liabilities totalling HK$42.6b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Hang Lung Properties is worth HK$77.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Strangely Hang Lung Properties has a sky high EBITDA ratio of 5.0, implying high debt, but a strong interest coverage of 27.7. So either it has access to very cheap long term debt or that interest expense is going to grow! The bad news is that Hang Lung Properties saw its EBIT decline by 12% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hang Lung Properties can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hang Lung Properties recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Both Hang Lung Properties's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle handle its debt, based on its EBITDA,. When we consider all the factors mentioned above, we do feel a bit cautious about Hang Lung Properties's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Given Hang Lung Properties 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.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.