Stock Analysis

We Think Dongguan Development (Holdings) (SZSE:000828) Is Taking Some Risk With Its Debt

SZSE:000828
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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Dongguan Development (Holdings) Co., Ltd. (SZSE:000828) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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.

See our latest analysis for Dongguan Development (Holdings)

How Much Debt Does Dongguan Development (Holdings) Carry?

As you can see below, Dongguan Development (Holdings) had CN¥10.1b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥2.35b in cash leading to net debt of about CN¥7.71b.

debt-equity-history-analysis
SZSE:000828 Debt to Equity History July 31st 2024

A Look At Dongguan Development (Holdings)'s Liabilities

The latest balance sheet data shows that Dongguan Development (Holdings) had liabilities of CN¥5.73b due within a year, and liabilities of CN¥4.80b falling due after that. Offsetting this, it had CN¥2.35b in cash and CN¥4.06b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.12b.

Dongguan Development (Holdings) has a market capitalization of CN¥10.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Dongguan Development (Holdings) has a fairly concerning net debt to EBITDA ratio of 5.9 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! One way Dongguan Development (Holdings) could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Dongguan Development (Holdings) 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. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Dongguan Development (Holdings) burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Dongguan Development (Holdings)'s ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We should also note that Infrastructure industry companies like Dongguan Development (Holdings) commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Dongguan Development (Holdings) is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Dongguan Development (Holdings) (at least 3 which don't sit too well with us) , 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.

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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.