Is China New Town Development (HKG:1278) Using Too Much Debt?

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.' 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 more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China New Town Development

What Is China New Town Development's Net Debt?

The image below, which you can click on for greater detail, shows that China New Town Development had debt of CN¥1.12b at the end of December 2021, a reduction from CN¥1.84b over a year. However, its balance sheet shows it holds CN¥1.77b in cash, so it actually has CN¥650.0m net cash.

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

The latest balance sheet data shows that China New Town Development had liabilities of CN¥1.37b due within a year, and liabilities of CN¥796.9m falling due after that. On the other hand, it had cash of CN¥1.77b and CN¥674.3m worth of receivables due within a year. So it actually has CN¥282.2m more liquid assets than total liabilities.

This surplus strongly suggests that China New Town Development has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, China New Town Development boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, China New Town Development turned things around in the last 12 months, delivering and EBIT of CN¥110m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China New Town Development will need earnings to service that debt. 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 year, 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 it is always sensible to investigate a company's debt, in this case China New Town Development has CN¥650.0m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥423m, being 383% 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 example - China New Town Development has 1 warning sign 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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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.