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 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. Importantly, SOHO China Limited (HKG:410) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is SOHO China's Debt?
The chart below, which you can click on for greater detail, shows that SOHO China had CN¥18.2b in debt in June 2019; about the same as the year before. On the flip side, it has CN¥1.15b in cash leading to net debt of about CN¥17.0b.
How Healthy Is SOHO China's Balance Sheet?
We can see from the most recent balance sheet that SOHO China had liabilities of CN¥7.39b falling due within a year, and liabilities of CN¥25.3b due beyond that. On the other hand, it had cash of CN¥1.15b and CN¥442.2m worth of receivables due within a year. So its liabilities total CN¥31.1b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥10.5b 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, SOHO China would probably need a major re-capitalization if its creditors were to demand repayment.
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).
With a net debt to EBITDA ratio of 11.2, it's fair to say SOHO China does have a significant amount of debt. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. However, one redeeming factor is that SOHO China grew its EBIT at 15% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SOHO China can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, SOHO China burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both SOHO China's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think SOHO China has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Over time, share prices tend to follow earnings per share, so if you're interested in SOHO China, you may well want to click here to check an interactive graph of its earnings per share history.
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.