In This Article:
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 Lai Sun Development Company Limited (HKG:488) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
View our latest analysis for Lai Sun Development
What Is Lai Sun Development's Net Debt?
The image below, which you can click on for greater detail, shows that at July 2019 Lai Sun Development had debt of HK$19.3b, up from HK$12.0b in one year. However, because it has a cash reserve of HK$5.04b, its net debt is less, at about HK$14.3b.
How Healthy Is Lai Sun Development's Balance Sheet?
We can see from the most recent balance sheet that Lai Sun Development had liabilities of HK$9.48b falling due within a year, and liabilities of HK$20.8b due beyond that. Offsetting these obligations, it had cash of HK$5.04b as well as receivables valued at HK$300.5m due within 12 months. So its liabilities total HK$24.9b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$5.82b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Lai Sun Development 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.