Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Greenland Hong Kong Holdings Limited (HKG:337) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Greenland Hong Kong Holdings

How Much Debt Does Greenland Hong Kong Holdings Carry?

As you can see below, Greenland Hong Kong Holdings had CN¥16.7b of debt at June 2022, down from CN¥25.1b a year prior. On the flip side, it has CN¥5.35b in cash leading to net debt of about CN¥11.4b.

How Healthy Is Greenland Hong Kong Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Greenland Hong Kong Holdings had liabilities of CN¥131.9b due within 12 months and liabilities of CN¥9.71b due beyond that. On the other hand, it had cash of CN¥5.35b and CN¥21.3b worth of receivables due within a year. So it has liabilities totalling CN¥115.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥1.51b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Greenland Hong Kong Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Greenland Hong Kong Holdings has a debt to EBITDA ratio of 3.4, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 25.6 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Greenland Hong Kong Holdings's EBIT fell a jaw-dropping 47% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Greenland Hong Kong 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Greenland Hong Kong Holdings recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Greenland Hong Kong 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. Overall, we think it's fair to say that Greenland Hong Kong Holdings has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 5 warning signs for Greenland Hong Kong Holdings that you should be aware of before investing here.

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.

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.