Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hysan Development Company Limited (HKG:14) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hysan Development's Debt?

As you can see below, at the end of June 2024, Hysan Development had HK$32.6b of debt, up from HK$30.9b a year ago. Click the image for more detail. However, it also had HK$1.71b in cash, and so its net debt is HK$30.9b.

How Healthy Is Hysan Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hysan Development had liabilities of HK$3.64b due within 12 months and liabilities of HK$32.5b due beyond that. Offsetting these obligations, it had cash of HK$1.71b as well as receivables valued at HK$342.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$34.1b.

This deficit casts a shadow over the HK$14.4b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Hysan Development would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Hysan Development has a fairly concerning net debt to EBITDA ratio of 13.1 but very strong interest coverage of 11.0. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. The bad news is that Hysan Development saw its EBIT decline by 11% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hysan Development'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Hysan Development generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

On the face of it, Hysan Development's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Hysan Development's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Hysan Development is showing 1 warning sign in our investment analysis , you should know about...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.