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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hang Lung Group Limited (HKG:10) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hang Lung Group

How Much Debt Does Hang Lung Group Carry?

As you can see below, at the end of December 2021, Hang Lung Group had HK$45.9b of debt, up from HK$38.8b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$9.02b, its net debt is less, at about HK$36.9b.

How Strong Is Hang Lung Group's Balance Sheet?

The latest balance sheet data shows that Hang Lung Group had liabilities of HK$19.5b due within a year, and liabilities of HK$54.1b falling due after that. Offsetting this, it had HK$9.02b in cash and HK$3.25b in receivables that were due within 12 months. So it has liabilities totalling HK$61.3b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$19.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hang Lung Group 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Hang Lung Group has a fairly concerning net debt to EBITDA ratio of 5.1 but very strong interest coverage of 20.9. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. If Hang Lung Group can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hang Lung Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Hang Lung Group recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Hang Lung Group's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Hang Lung Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Hang Lung Group is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.