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.' 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 note that The Wharf (Holdings) Limited (HKG:4) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

How Much Debt Does Wharf (Holdings) Carry?

The image below, which you can click on for greater detail, shows that Wharf (Holdings) had debt of HK$19.3b at the end of June 2024, a reduction from HK$23.9b over a year. However, it also had HK$10.6b in cash, and so its net debt is HK$8.67b.

How Healthy Is Wharf (Holdings)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Wharf (Holdings) had liabilities of HK$22.2b due within 12 months and liabilities of HK$27.9b due beyond that. Offsetting this, it had HK$10.6b in cash and HK$1.77b in receivables that were due within 12 months. So it has liabilities totalling HK$37.7b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$62.5b, so it does suggest shareholders should keep an eye on Wharf (Holdings)'s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Wharf (Holdings) has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 12.2 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Wharf (Holdings) has increased its EBIT by 9.2% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Wharf (Holdings) can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, Wharf (Holdings) recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Wharf (Holdings)'s impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Wharf (Holdings) takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. We'd be motivated to research the stock further if we found out that Wharf (Holdings) insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.