New World Development (HKG:17) Has No Shortage Of 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies New World Development Company Limited (HKG:17) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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 New World Development

What Is New World Development's Net Debt?

The chart below, which you can click on for greater detail, shows that New World Development had HK$183.7b in debt in December 2021; about the same as the year before. On the flip side, it has HK$57.1b in cash leading to net debt of about HK$126.6b.

How Healthy Is New World Development's Balance Sheet?

We can see from the most recent balance sheet that New World Development had liabilities of HK$175.1b falling due within a year, and liabilities of HK$163.9b due beyond that. On the other hand, it had cash of HK$57.1b and HK$36.9b worth of receivables due within a year. So it has liabilities totalling HK$245.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$70.0b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, New World Development would likely require a major re-capitalisation if it had to pay its creditors today.

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.

As it happens New World Development has a fairly concerning net debt to EBITDA ratio of 22.0 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that New World Development's EBIT was down 58% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if New World Development 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, New World Development burned a lot of cash. 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.

Our View

On the face of it, New World Development's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Considering all the factors previously mentioned, we think that New World Development really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Case in point: We've spotted 3 warning signs for New World Development you should be aware of, and 2 of them are significant.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.