The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Bright Real Estate Group Co.,Limited (SHSE:600708) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Bright Real Estate GroupLimited's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Bright Real Estate GroupLimited had debt of CN¥32.8b, up from CN¥30.1b in one year. However, it does have CN¥5.27b in cash offsetting this, leading to net debt of about CN¥27.6b.

How Healthy Is Bright Real Estate GroupLimited's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Bright Real Estate GroupLimited had liabilities of CN¥21.7b due within 12 months and liabilities of CN¥30.6b due beyond that. Offsetting these obligations, it had cash of CN¥5.27b as well as receivables valued at CN¥9.50b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥37.5b.

This deficit casts a shadow over the CN¥4.57b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Bright Real Estate GroupLimited would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Bright Real Estate GroupLimited has a rather high debt to EBITDA ratio of 37.8 which suggests a meaningful debt load. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. Even worse, Bright Real Estate GroupLimited saw its EBIT tank 61% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Bright Real Estate GroupLimited will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Bright Real Estate GroupLimited actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Bright Real Estate GroupLimited's EBIT growth rate 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. We're quite clear that we consider Bright Real Estate GroupLimited to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Bright Real Estate GroupLimited that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.