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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hongkong Land Holdings Limited (SGX:H78) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Hongkong Land Holdings's Debt?

As you can see below, Hongkong Land Holdings had US$6.43b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$1.07b, its net debt is less, at about US$5.36b.

How Strong Is Hongkong Land Holdings' Balance Sheet?

According to the last reported balance sheet, Hongkong Land Holdings had liabilities of US$2.23b due within 12 months, and liabilities of US$6.04b due beyond 12 months. Offsetting these obligations, it had cash of US$1.07b as well as receivables valued at US$385.1m due within 12 months. So it has liabilities totalling US$6.82b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$8.27b, so it does suggest shareholders should keep an eye on Hongkong Land Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hongkong Land Holdings has a rather high debt to EBITDA ratio of 8.5 which suggests a meaningful debt load. However, its interest coverage of 5.2 is reasonably strong, which is a good sign. Shareholders should be aware that Hongkong Land Holdings's EBIT was down 24% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hongkong Land Holdings'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Hongkong Land Holdings produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Hongkong Land Holdings's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Hongkong Land Holdings's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Hongkong Land Holdings 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.