Here's Why China New Town Development (HKG:1278) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies China New Town Development Company Limited (HKG:1278) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 China New Town Development

How Much Debt Does China New Town Development Carry?

You can click the graphic below for the historical numbers, but it shows that China New Town Development had CN¥1.82b of debt in December 2020, down from CN¥2.75b, one year before. But it also has CN¥2.85b in cash to offset that, meaning it has CN¥1.03b net cash.

How Strong 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¥2.21b due within 12 months and liabilities of CN¥817.1m due beyond that. Offsetting this, it had CN¥2.85b in cash and CN¥1.23b in receivables that were due within 12 months. So it can boast 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 view, lenders should feel as safe as the beloved of a black-belt karate master. 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.

It is well worth noting that China New Town Development's EBIT shot up like bamboo after rain, gaining 69% in the last twelve months. That'll make it easier to manage its debt. 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 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 China New Town Development 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. Over the last three years, China New Town Development saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While it is always sensible to investigate a company's debt, in this case China New Town Development has CN¥1.03b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 69% over the last year. So we don't think China New Town Development's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - China New Town Development has 2 warning signs we think 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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