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. As with many other companies CCCG Real Estate Company Limited (SZSE:000736) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 examine debt levels, we first consider both cash and debt levels, together.
What Is CCCG Real Estate's Debt?
As you can see below, CCCG Real Estate had CN¥17.9b of debt at September 2024, down from CN¥43.4b a year prior. However, because it has a cash reserve of CN¥9.94b, its net debt is less, at about CN¥7.97b.
A Look At CCCG Real Estate's Liabilities
According to the last reported balance sheet, CCCG Real Estate had liabilities of CN¥73.3b due within 12 months, and liabilities of CN¥27.1b due beyond 12 months. Offsetting this, it had CN¥9.94b in cash and CN¥5.88b in receivables that were due within 12 months. So it has liabilities totalling CN¥84.7b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥4.06b 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, CCCG Real Estate would probably need a major re-capitalization if its creditors were to demand repayment.
Check out our latest analysis for CCCG Real Estate
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 0.10 times and a disturbingly high net debt to EBITDA ratio of 55.1 hit our confidence in CCCG Real Estate like a one-two punch to the gut. The debt burden here is substantial. Even worse, CCCG Real Estate saw its EBIT tank 93% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is CCCG Real Estate's earnings that will influence how the balance sheet holds up in the future. 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, CCCG Real Estate actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
On the face of it, CCCG Real Estate'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. After considering the datapoints discussed, we think CCCG Real Estate 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. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with CCCG Real Estate , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
Valuation is complex, but we're here to simplify it.
Discover if CCCG Real Estate might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.
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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.