Smart City Development Holdings (HKG:8268) Seems To Use Debt Quite Sensibly

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 can see that Smart City Development Holdings Limited (HKG:8268) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Smart City Development Holdings

What Is Smart City Development Holdings's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Smart City Development Holdings had debt of HK$18.5m, up from HK$11.4m in one year. However, it does have HK$175.7m in cash offsetting this, leading to net cash of HK$157.2m.

How Healthy Is Smart City Development Holdings's Balance Sheet?

According to the last reported balance sheet, Smart City Development Holdings had liabilities of HK$322.7m due within 12 months, and liabilities of HK$1.03m due beyond 12 months. Offsetting these obligations, it had cash of HK$175.7m as well as receivables valued at HK$156.3m due within 12 months. So it actually has HK$8.32m more liquid assets than total liabilities.

This surplus suggests that Smart City Development Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Smart City Development Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Smart City Development Holdings made a loss at the EBIT level, last year, it was also good to see that it generated HK$665k in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Smart City Development Holdings's earnings that will influence how the balance sheet holds up in the future. 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. While Smart City Development Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last year, Smart City 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.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Smart City Development Holdings has net cash of HK$157.2m, as well as more liquid assets than liabilities. So we are not troubled with Smart City Development Holdings's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Smart City Development Holdings has 4 warning signs (and 2 which don't sit too well with us) we think you should know about.

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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