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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that China New Town Development Company Limited (HKG:1278) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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?

The image below, which you can click on for greater detail, shows that at June 2022 China New Town Development had debt of CN¥1.13b, up from CN¥879.3m in one year. But it also has CN¥1.52b in cash to offset that, meaning it has CN¥389.8m net cash.

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

The latest balance sheet data shows that China New Town Development had liabilities of CN¥1.28b due within a year, and liabilities of CN¥761.6m falling due after that. Offsetting these obligations, it had cash of CN¥1.52b as well as receivables valued at CN¥643.1m due within 12 months. So it can boast CN¥128.1m more liquid assets than total liabilities.

This excess liquidity suggests that China New Town Development is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. 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.

In fact China New Town Development's saving grace is its low debt levels, because its EBIT has tanked 67% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 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 most recent three years, China New Town Development recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case China New Town Development has CN¥389.8m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of -CN¥36m, being 75% of its EBIT. So we don't think China New Town Development's use of debt is risky. 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. To that end, you should learn about the 3 warning signs we've spotted with China New Town Development (including 1 which doesn't sit too well with us) .

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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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.