Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think about the risk level of a business, we always like to look at its use of debt because debt overload can lead to bankruptcy. Mostly, Guorui Properties Limited (HKG: 2329) is in debt. But should shareholders be worried about its use of debt?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to issue shares at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially large cap companies. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Discover our latest analyzes for Guorui Properties
What is the debt of Guorui Properties?
The image below, which you can click for more details, shows that Guorui Properties had a debt of 23.5 billion yen at the end of December 2020, a reduction of 27.4 billion yen on a year. However, because it has a cash reserve of 1.65 billion yen, its net debt is less, at around 21.9 billion yen.
How healthy is Guorui Properties’ balance sheet?
We can see from the most recent balance sheet that Guorui Properties had liabilities of CNY 34.1 billion maturing within one year and liabilities of CNY 18.3 billion due beyond. On the other hand, he had a cash position of 1.65 billion yen and 6.39 billion yen in receivables due within one year. Its liabilities therefore total 44.4 billion yen more than the combination of its cash and short-term receivables.
Deficiency here weighs heavily on the 1.53 billion yen CN company itself, as if a child struggles under the weight of a huge backpack full of books, his gym equipment and a trumpet. . We therefore clearly believe that shareholders should monitor this closely. After all, Guorui Properties would likely need a major recapitalization if it were to pay its creditors today.
We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) cover his interests. costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
Low interest coverage of 0.66 times and an extremely high Net Debt to EBITDA ratio of 68.4 hit our confidence in Guorui Properties like a punch in the gut. The debt burden here is considerable. Worse yet, Guorui Properties’ EBIT was down 81% from last year. If profits continue to follow this path, paying off that debt will be more difficult than convincing us to run a marathon in the rain. When analyzing debt levels, the balance sheet is the obvious starting point. But you cannot view the debt in total isolation; since Guorui Properties will need income to repay this debt. So when you consider debt, it’s really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits do not reduce it. We must therefore clearly consider whether this EBIT leads to a corresponding free cash flow. Fortunately for all shareholders, Guorui Properties has actually produced more free cash flow than EBIT over the past three years. This kind of big cash conversion turns us on as much as the crowd when the beat drops at a Daft Punk concert.
Our point of view
To be frank, Guorui Properties’ EBIT growth rate and track record of controlling its total liabilities make us quite uncomfortable with its debt levels. But on the bright side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. After looking at the data points discussed, we believe that Guorui Properties has too much debt. This kind of risk is acceptable to some, but it certainly does not float our boat. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. To this end, you should inquire about the 5 warning signs we spotted with Guorui Properties (including 2 which are significant).
Of course, if you are the type of investor who prefers to buy stocks without the burden of debt, feel free to check out our exclusive list of cash net growth stocks today.
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