The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Powerlong Real Estate Holdings Limited (HKG:1238) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Powerlong Real Estate Holdings

How Much Debt Does Powerlong Real Estate Holdings Carry?

As you can see below, Powerlong Real Estate Holdings had CN¥66.6b of debt at June 2022, down from CN¥71.4b a year prior. On the flip side, it has CN¥14.9b in cash leading to net debt of about CN¥51.7b.

How Strong Is Powerlong Real Estate Holdings' Balance Sheet?

We can see from the most recent balance sheet that Powerlong Real Estate Holdings had liabilities of CN¥113.1b falling due within a year, and liabilities of CN¥62.9b due beyond that. Offsetting these obligations, it had cash of CN¥14.9b as well as receivables valued at CN¥27.1b due within 12 months. So its liabilities total CN¥134.0b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥3.42b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Powerlong Real Estate Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Powerlong Real Estate Holdings has a fairly concerning net debt to EBITDA ratio of 8.2 but very strong interest coverage of 11.6. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Powerlong Real Estate Holdings's EBIT was down 45% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Powerlong Real Estate 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Powerlong Real Estate Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Powerlong Real Estate 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 interest cover is a good sign, and makes us more optimistic. Considering all the factors previously mentioned, we think that Powerlong Real Estate Holdings really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Powerlong Real Estate Holdings (including 1 which is potentially serious) .

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.