Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Hang Lung Group Limited (HKG:10) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.

What Is Hang Lung Group's Debt?

As you can see below, at the end of December 2023, Hang Lung Group had HK$50.7b of debt, up from HK$46.0b a year ago. Click the image for more detail. However, it does have HK$6.34b in cash offsetting this, leading to net debt of about HK$44.4b.

A Look At Hang Lung Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Hang Lung Group had liabilities of HK$15.1b due within 12 months and liabilities of HK$61.5b due beyond that. On the other hand, it had cash of HK$6.34b and HK$3.17b worth of receivables due within a year. So its liabilities total HK$67.0b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$12.1b 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'd watch its balance sheet closely, without a doubt. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Strangely Hang Lung Group has a sky high EBITDA ratio of 6.1, implying high debt, but a strong interest coverage of 14.0. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably Hang Lung Group's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hang Lung Group will need earnings to service that debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hang Lung Group produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Hang Lung Group's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Hang Lung Group's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 - Hang Lung Group has 1 warning sign we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.