China New Town Development (HKG:1278) Seems To Use Debt Quite Sensibly

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, China New Town Development Company Limited (HKG:1278) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China New Town Development

What Is China New Town Development's Net Debt?

You can click the graphic below for the historical numbers, but it shows that China New Town Development had CN¥2.19b of debt in June 2020, down from CN¥2.85b, one year before. However, its balance sheet shows it holds CN¥3.19b in cash, so it actually has CN¥998.0m net cash.

How Healthy Is China New Town Development's Balance Sheet?

According to the last reported balance sheet, China New Town Development had liabilities of CN¥2.58b due within 12 months, and liabilities of CN¥839.3m due beyond 12 months. On the other hand, it had cash of CN¥3.19b and CN¥1.29b worth of receivables due within a year. So it actually has CN¥1.06b more liquid assets than total liabilities.

This surplus liquidity suggests that China New Town Development's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, China New Town Development boasts net cash, so it's fair to say it does not have a heavy debt load!

Notably, China New Town Development's EBIT launched higher than Elon Musk, gaining a whopping 129% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is China New Town Development's earnings that will influence how the balance sheet holds up in the future. 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 company can only pay off debt with cold hard cash, not accounting profits. China New Town Development may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, China New Town 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.

Summing up

While it is always sensible to investigate a company's debt, in this case China New Town Development has CN¥998.0m in net cash and a decent-looking balance sheet. And we liked the look of last year's 129% year-on-year EBIT growth. So we are not troubled with China New Town Development's debt use. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 6 warning signs with China New Town Development (at least 2 which can't be ignored) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

When trading China New Town Development or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.