Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that China Overseas Land & Investment Limited (HKG: 688) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
Check out our latest analysis for China Overseas Land & Investment
What is China’s land and investment debt abroad?
You can click on the graph below for historical figures, but it shows that as of June 2021, China Overseas Land & Investment had a debt of CNN 228.5 billion, an increase from CNN 210.3 billion. CN, over one year. However, he also had CN 117.4 billion in cash, so his net debt was CN 111.0 billion.
How strong is China Overseas Land & Investment’s balance sheet?
The latest balance sheet data shows that China Overseas Land & Investment had a liability of CN ¥ 312.1b due within one year, and a liability of CN ¥ 205.0b due after that. In return, he had CN 117.4 billion in cash and CN 32.6 billion in receivables due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by CN 367.1b.
The deficiency here weighs heavily on the CN ¥ 163.3b company itself, as if a child struggles under the weight of a huge backpack full of books, his sports equipment, and a trumpet. We therefore believe that shareholders should monitor it closely. Ultimately, China Overseas Land & Investment would likely need a major recapitalization if its creditors demanded repayment.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization charges.
China Overseas Land & Investment’s net debt to EBITDA ratio of around 2.0 suggests only moderate use of debt. And its high interest coverage of 1k times, makes us even more comfortable. China Overseas Land & Investment increased its EBIT by 9.7% last year. While this hardly strikes us, it is a bright spot when it comes to debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine China Overseas Land & Investment’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 analyst earnings forecast report interesting.
Finally, a business can only repay its debts with hard cash, not with book profits. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, China Overseas Land & Investment has posted free cash flow of 15% of its EBIT, which is really quite low. For us, the conversion to cash that elicits a bit of paranoia is the ability to extinguish debt.
Our point of view
Reflecting on China Overseas Land & Investment’s attempt to stay on top of its total liabilities, we are certainly not enthusiastic. But at least it’s decent enough to cover its interest costs with its EBIT; it’s encouraging. From a broader perspective, it seems clear to us that the use of debt by China Overseas Land & Investment creates risks for the company. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 1 warning sign with China Overseas Land & Investment, and understanding them should be part of your investment process.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of net cash growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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