David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Longfor Group Holdings Limited (HKG:960) 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Longfor Group Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2018 Longfor Group Holdings had debt of CN¥127.4b, up from CN¥84.3b in one year. However, it also had CN¥45.1b in cash, and so its net debt is CN¥82.4b.
How Strong Is Longfor Group Holdings's Balance Sheet?
We can see from the most recent balance sheet that Longfor Group Holdings had liabilities of CN¥249.8b falling due within a year, and liabilities of CN¥116.2b due beyond that. On the other hand, it had cash of CN¥45.1b and CN¥65.0b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥255.9b.
This deficit casts a shadow over the CN¥159.8b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Longfor Group Holdings 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). 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).
Longfor Group Holdings has a debt to EBITDA ratio of 2.6, which betrays significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 1k is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. Importantly, Longfor Group Holdings grew its EBIT by 60% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Longfor Group 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Longfor Group Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Based on what we've seen Longfor Group Holdings is not finding it easy level of total liabilities, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Longfor Group 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. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Longfor Group Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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