The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that China Chengtong Development Group Limited (HKG:217) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is China Chengtong Development Group’s Debt?
As you can see below, China Chengtong Development Group had HK$200.6m of debt at June 2019, down from HK$220.9m a year prior. But it also has HK$1.72b in cash to offset that, meaning it has HK$1.52b net cash.
A Look At China Chengtong Development Group’s Liabilities
According to the last reported balance sheet, China Chengtong Development Group had liabilities of HK$527.5m due within 12 months, and liabilities of HK$45.3m due beyond 12 months. Offsetting this, it had HK$1.72b in cash and HK$358.3m in receivables that were due within 12 months. So it can boast HK$1.51b more liquid assets than total liabilities.
This surplus strongly suggests that China Chengtong Development Group has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, it seems its balance sheet is as strong as a black-belt karate master. Simply put, the fact that China Chengtong Development Group has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact China Chengtong Development Group’s saving grace is its low debt levels, because its EBIT has tanked 89% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since China Chengtong Development Group will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. While China Chengtong Development Group has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, China Chengtong Development Group actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
While we empathize with investors who find debt concerning, the bottom line is that China Chengtong Development Group has net cash of HK$1.52b and plenty of liquid assets. The cherry on top was that in converted 178% of that EBIT to free cash flow, bringing in -HK$177.8m. So we don’t think China Chengtong Development Group’s use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of China Chengtong Development Group’s earnings per share history for free.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.