Central China Real Estate (HKG:832) Seems To Be Using A Lot Of Debt

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Central China Real Estate Limited (HKG:832) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Central China Real Estate

How Much Debt Does Central China Real Estate Carry?

The image below, which you can click on for greater detail, shows that Central China Real Estate had debt of CN¥22.1b at the end of December 2021, a reduction from CN¥31.5b over a year. However, it does have CN¥7.46b in cash offsetting this, leading to net debt of about CN¥14.7b.

How Strong Is Central China Real Estate's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Central China Real Estate had liabilities of CN¥115.8b due within 12 months and liabilities of CN¥17.2b due beyond that. On the other hand, it had cash of CN¥7.46b and CN¥9.31b worth of receivables due within a year. So its liabilities total CN¥116.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥1.42b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Central China Real Estate 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Central China Real Estate's debt to EBITDA ratio of 5.8 suggests a heavy debt load, its interest coverage of 8.0 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. Shareholders should be aware that Central China Real Estate's EBIT was down 44% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Central China Real Estate's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Central China Real Estate's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Central China Real Estate'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 on the bright side, its interest cover is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Central China Real Estate has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Central China Real Estate is showing 5 warning signs in our investment analysis , and 1 of those is potentially serious...

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.