China South City Holdings (HKG:1668) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 South City Holdings Limited (HKG:1668) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 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.

See our latest analysis for China South City Holdings

What Is China South City Holdings's Debt?

As you can see below, at the end of September 2020, China South City Holdings had HK$35.5b of debt, up from HK$32.5b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$10.6b, its net debt is less, at about HK$24.9b.

How Healthy Is China South City Holdings's Balance Sheet?

According to the last reported balance sheet, China South City Holdings had liabilities of HK$48.2b due within 12 months, and liabilities of HK$29.3b due beyond 12 months. Offsetting this, it had HK$10.6b in cash and HK$653.5m in receivables that were due within 12 months. So its liabilities total HK$66.2b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$8.25b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, China South City Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China South City Holdings has a rather high debt to EBITDA ratio of 7.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 6.5 times, suggesting it can responsibly service its obligations. Also relevant is that China South City Holdings has grown its EBIT by a very respectable 27% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China South City Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, China South City Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We feel some trepidation about China South City Holdings's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. We think that China South City Holdings's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with China South City Holdings (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.
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