Here's Why Central Development Holdings (HKG:475) Can Afford Some Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Central Development Holdings Limited (HKG:475) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Central Development Holdings

How Much Debt Does Central Development Holdings Carry?

The image below, which you can click on for greater detail, shows that Central Development Holdings had debt of HK$113.8m at the end of September 2020, a reduction from HK$142.7m over a year. However, because it has a cash reserve of HK$40.4m, its net debt is less, at about HK$73.4m.

How Strong Is Central Development Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Central Development Holdings had liabilities of HK$33.6m due within 12 months and liabilities of HK$116.4m due beyond that. On the other hand, it had cash of HK$40.4m and HK$16.5m worth of receivables due within a year. So its liabilities total HK$93.1m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Central Development Holdings has a market capitalization of HK$286.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. When analysing debt levels, the balance sheet is the obvious place to start. But it is Central 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.

In the last year Central Development Holdings had a loss before interest and tax, and actually shrunk its revenue by 67%, to HK$59m. That makes us nervous, to say the least.

Caveat Emptor

While Central Development Holdings's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable HK$31m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled HK$14m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. 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. Be aware that Central Development Holdings is showing 2 warning signs in our investment analysis , you should know about...

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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