These 4 Measures Indicate That Hefei Urban Construction Development (SZSE:002208) Is Using Debt Extensively

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, Hefei Urban Construction Development Co., Ltd (SZSE:002208) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Hefei Urban Construction Development

What Is Hefei Urban Construction Development's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Hefei Urban Construction Development had debt of CN¥9.94b, up from CN¥9.02b in one year. On the flip side, it has CN¥3.71b in cash leading to net debt of about CN¥6.23b.

A Look At Hefei Urban Construction Development's Liabilities

The latest balance sheet data shows that Hefei Urban Construction Development had liabilities of CN¥20.8b due within a year, and liabilities of CN¥6.20b falling due after that. On the other hand, it had cash of CN¥3.71b and CN¥3.75b worth of receivables due within a year. So it has liabilities totalling CN¥19.5b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥5.78b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Hefei Urban Construction Development would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While Hefei Urban Construction Development's debt to EBITDA ratio of 6.1 suggests a heavy debt load, its interest coverage of 7.7 implies it services that debt with ease. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. We note that Hefei Urban Construction Development grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hefei Urban Construction Development saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far 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 it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Hefei Urban Construction Development's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that Hefei Urban Construction Development is showing 5 warning signs in our investment analysis , and 3 of those are potentially serious...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.