Hefei Urban Construction Development (SZSE:002208) Has No Shortage Of Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hefei Urban Construction Development Co., Ltd (SZSE:002208) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

View our latest analysis for Hefei Urban Construction Development

What Is Hefei Urban Construction Development's Net Debt?

The image below, which you can click on for greater detail, shows that Hefei Urban Construction Development had debt of CN¥9.51b at the end of June 2024, a reduction from CN¥10.2b over a year. However, it does have CN¥3.79b in cash offsetting this, leading to net debt of about CN¥5.71b.

A Look At Hefei Urban Construction Development's Liabilities

We can see from the most recent balance sheet that Hefei Urban Construction Development had liabilities of CN¥21.9b falling due within a year, and liabilities of CN¥7.56b due beyond that. Offsetting this, it had CN¥3.79b in cash and CN¥3.63b in receivables that were due within 12 months. So it has liabilities totalling CN¥22.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥6.12b 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, Hefei Urban Construction Development 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.

Hefei Urban Construction Development has a rather high debt to EBITDA ratio of 10.0 which suggests a meaningful debt load. However, its interest coverage of 5.8 is reasonably strong, which is a good sign. Unfortunately, Hefei Urban Construction Development's EBIT flopped 17% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Hefei Urban Construction Development 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hefei Urban Construction Development burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Hefei Urban Construction Development's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its interest cover is not so bad. Considering all the factors previously mentioned, we think that Hefei Urban Construction Development really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 5 warning signs for Hefei Urban Construction Development (3 are a bit unpleasant) you should be aware of.

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.

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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.