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.' 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. As with many other companies SOHO China Limited (HKG:410) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does SOHO China Carry?

As you can see below, SOHO China had CN¥15.9b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥769.5m in cash offsetting this, leading to net debt of about CN¥15.1b.

A Look At SOHO China's Liabilities

According to the last reported balance sheet, SOHO China had liabilities of CN¥10.5b due within 12 months, and liabilities of CN¥21.0b due beyond 12 months. Offsetting these obligations, it had cash of CN¥769.5m as well as receivables valued at CN¥535.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥30.1b.

This deficit casts a shadow over the CN¥3.61b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, SOHO China 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.

SOHO China shareholders face the double whammy of a high net debt to EBITDA ratio (14.5), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. The debt burden here is substantial. Investors should also be troubled by the fact that SOHO China saw its EBIT drop by 17% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since SOHO China 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, SOHO China reported free cash flow worth 19% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both SOHO China's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its EBIT growth rate fails to inspire much confidence. Considering all the factors previously mentioned, we think that SOHO China really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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 instance, we've identified 2 warning signs for SOHO China that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.