Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Wharf Real Estate Investment Company Limited (HKG:1997) has a debt on its balance sheet. But the more important question is: what risk does this debt create?

What risk does debt carry?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Wharf Real Estate Investment

How much debt does Wharf Real Estate Investment have?

As you can see below, Wharf Real Estate Investment had HK$51.1 billion in debt as of June 2022, up from HK$53.8 billion the previous year. On the other hand, he has HK$1.80 billion in cash, resulting in a net debt of around HK$49.3 billion.

SEHK: 1997 Debt to Equity August 28, 2022

How strong is Wharf Real Estate Investment’s balance sheet?

Zooming in on the latest balance sheet data, we can see that Wharf Real Estate Investment had liabilities of HK$13.4 billion due within 12 months and liabilities of HK$48.8 billion due beyond. As compensation for these obligations, it had cash of HK$1.80 billion and receivables valued at HK$1.53 billion due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of HK$58.9 billion.

While that might sound like a lot, it’s not that bad since Wharf Real Estate Investment has a huge market capitalization of HK$112.3 billion, and so it could probably bolster its balance sheet by raising capital if needed. But we definitely want to keep our eyes peeled for indications that its debt is too risky.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.

Wharf Real Estate Investment’s net debt to EBITDA ratio is 5.2, suggesting rather high debt levels, but its 10.0x interest coverage suggests debt is easily repaid. Our best guess is that the company does indeed have significant debt. Unfortunately, Wharf Real Estate Investment’s EBIT actually fell 3.7% over the past year. If this earnings trend continues, its leverage will become heavy like the heart of a polar bear looking at its only cub. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Wharf Real Estate Investment’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Wharf Real Estate Investment has recorded free cash flow of 74% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.

Our point of view

Wharf Real Estate Investment’s conversion of EBIT to free cash flow was a real benefit in this analysis, as was its interest coverage. But truth be told, its net debt to EBITDA had us biting our nails. Looking at all this data, we feel a bit cautious about Wharf Real Estate Investment’s debt levels. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels could make the stock more risky. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for Wharf Real Estate Investment you should know.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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