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.' 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. We can see that Hopson Development Holdings Limited (HKG:754) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
View our latest analysis for Hopson Development Holdings
What Is Hopson Development Holdings's Net Debt?
As you can see below, Hopson Development Holdings had HK$90.7b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$22.3b in cash offsetting this, leading to net debt of about HK$68.4b.
How Strong Is Hopson Development Holdings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hopson Development Holdings had liabilities of HK$111.9b due within 12 months and liabilities of HK$75.1b due beyond that. Offsetting these obligations, it had cash of HK$22.3b as well as receivables valued at HK$16.0b due within 12 months. So its liabilities total HK$148.6b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$13.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hopson Development Holdings 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.
Hopson Development Holdings has a rather high debt to EBITDA ratio of 20.0 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.8 times, suggesting it can responsibly service its obligations. Shareholders should be aware that Hopson Development Holdings's EBIT was down 48% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hopson Development Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Hopson Development Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
To be frank both Hopson Development Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Hopson Development Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example Hopson Development Holdings has 4 warning signs (and 2 which are concerning) we think you should know about.
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.
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.