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

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies China New Town Development Company Limited (HKG:1278) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China New Town Development

What Is China New Town Development's Debt?

As you can see below, China New Town Development had CN¥879.3m of debt at June 2021, down from CN¥2.19b a year prior. But on the other hand it also has CN¥2.54b in cash, leading to a CN¥1.66b net cash position.

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

Zooming in on the latest balance sheet data, we can see that China New Town Development had liabilities of CN¥1.10b due within 12 months and liabilities of CN¥826.7m due beyond that. On the other hand, it had cash of CN¥2.54b and CN¥711.7m worth of receivables due within a year. So it can boast CN¥1.32b more liquid assets than total liabilities.

This excess liquidity is a great indication that China New Town Development's balance sheet is almost as strong as Fort Knox. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that China New Town Development has more cash than debt is arguably a good indication that it can manage its debt safely.

Shareholders should be aware that China New Town Development's EBIT was down 21% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is China New Town Development'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. 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 actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While we empathize with investors who find debt concerning, the bottom line is that China New Town Development has net cash of CN¥1.66b and plenty of liquid assets. And it impressed us with free cash flow of CN¥457m, being 107% of its EBIT. So is China New Town Development's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 3 warning signs for China New Town Development (1 is a bit unpleasant) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.