Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Yanlord Land Group Limited (SGX:Z25) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Yanlord Land Group's Net Debt?

It shows that Yanlord Land Group had CN¥26.4b of debt in June 2024, down from CN¥55.3b, one year before. However, it does have CN¥10.7b in cash offsetting this, leading to net debt of about CN¥15.7b.

How Healthy Is Yanlord Land Group's Balance Sheet?

According to the last reported balance sheet, Yanlord Land Group had liabilities of CN¥63.1b due within 12 months, and liabilities of CN¥29.9b due beyond 12 months. Offsetting these obligations, it had cash of CN¥10.7b as well as receivables valued at CN¥21.9b due within 12 months. So its liabilities total CN¥60.5b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥6.65b 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, Yanlord Land Group 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.0, it's fair to say Yanlord Land Group does have a significant amount of debt. However, its interest coverage of 2.6 is reasonably strong, which is a good sign. Worse, Yanlord Land Group's EBIT was down 45% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Yanlord Land Group's ability to maintain a healthy balance sheet going forward.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Yanlord Land Group recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Yanlord Land Group's EBIT growth rate 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 converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Yanlord Land Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it.