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 can see that DaFa Properties Group Limited (HKG:6111) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is DaFa Properties Group's Net Debt?
As you can see below, DaFa Properties Group had CN¥5.65b of debt at December 2018, down from CN¥5.99b a year prior. However, because it has a cash reserve of CN¥1.51b, its net debt is less, at about CN¥4.14b.
How Strong Is DaFa Properties Group's Balance Sheet?
The latest balance sheet data shows that DaFa Properties Group had liabilities of CN¥12.2b due within a year, and liabilities of CN¥3.85b falling due after that. On the other hand, it had cash of CN¥1.51b and CN¥1.47b worth of receivables due within a year. So its liabilities total CN¥13.0b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥4.34b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, DaFa Properties Group would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt to EBITDA of 4.0 DaFa Properties Group has a fairly reasonable amount of debt. But the high interest coverage of 9.0 suggests it can easily service that debt. Notably, DaFa Properties Group's EBIT launched higher than Elon Musk, gaining a whopping 140% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is DaFa Properties Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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 two years, DaFa Properties Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, DaFa Properties Group's conversion of EBIT to free cash flow 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, we think it's fair to say that DaFa Properties Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you're interested in DaFa Properties Group, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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.