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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. We can see that China South City Holdings Limited (HKG:1668) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for China South City Holdings
How Much Debt Does China South City Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that China South City Holdings had HK$34.3b of debt in March 2019, down from HK$38.8b, one year before. However, it does have HK$8.60b in cash offsetting this, leading to net debt of about HK$25.7b.
A Look At China South City Holdings's Liabilities
The latest balance sheet data shows that China South City Holdings had liabilities of HK$48.9b due within a year, and liabilities of HK$28.1b falling due after that. Offsetting these obligations, it had cash of HK$8.60b as well as receivables valued at HK$1.16b due within 12 months. So it has liabilities totalling HK$67.2b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$7.95b 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, China South City Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.