Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Modern Land (China) Co., Limited (HKG:1107) makes use of debt. But the more important question is: how much risk is that debt creating?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Modern Land (China) Carry?
As you can see below, Modern Land (China) had CN¥17.9b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have CN¥7.34b in cash offsetting this, leading to net debt of about CN¥10.6b.
How Strong Is Modern Land (China)'s Balance Sheet?
We can see from the most recent balance sheet that Modern Land (China) had liabilities of CN¥39.7b falling due within a year, and liabilities of CN¥9.50b due beyond that. Offsetting these obligations, it had cash of CN¥7.34b as well as receivables valued at CN¥5.18b due within 12 months. So its liabilities total CN¥36.7b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥2.93b 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, Modern Land (China) would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Modern Land (China) has net debt to EBITDA of 4.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.6 times its interest expense, and its net debt to EBITDA, was quite high, at 4.7. Pleasingly, Modern Land (China) is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 130% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Modern Land (China)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. In the last three years, Modern Land (China) created free cash flow amounting to 13% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Mulling over Modern Land (China)'s attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Modern Land (China)'s debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Given our hesitation about the stock, it would be good to know if Modern Land (China) insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
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