Beijing Urban Construction Design & Development Group (HKG:1599) Takes On Some Risk With Its Use 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.' 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. Importantly, Beijing Urban Construction Design & Development Group Co., Limited (HKG:1599) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

Check out our latest analysis for Beijing Urban Construction Design & Development Group

How Much Debt Does Beijing Urban Construction Design & Development Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Beijing Urban Construction Design & Development Group had CN¥5.30b of debt, an increase on CN¥4.92b, over one year. On the flip side, it has CN¥3.53b in cash leading to net debt of about CN¥1.77b.

A Look At Beijing Urban Construction Design & Development Group's Liabilities

The latest balance sheet data shows that Beijing Urban Construction Design & Development Group had liabilities of CN¥9.83b due within a year, and liabilities of CN¥5.48b falling due after that. Offsetting these obligations, it had cash of CN¥3.53b as well as receivables valued at CN¥7.42b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.36b.

The deficiency here weighs heavily on the CN¥2.52b 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 definitely think shareholders need to watch this one closely. At the end of the day, Beijing Urban Construction Design & Development Group would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Beijing Urban Construction Design & Development Group's moderate net debt to EBITDA ratio ( being 2.4), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. One way Beijing Urban Construction Design & Development Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Beijing Urban Construction Design & Development Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, Beijing Urban Construction Design & Development Group's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Beijing Urban Construction Design & Development Group's level of total liabilities was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Beijing Urban Construction Design & Development Group's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For example Beijing Urban Construction Design & Development Group has 2 warning signs (and 1 which is a bit concerning) we think you should know about.

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.

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