Is Central China Real Estate (HKG:832) Using Debt Sensibly?

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.' 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 Central China Real Estate Limited (HKG:832) makes use of debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

Our analysis indicates that 832 is potentially undervalued!

What Is Central China Real Estate's Net Debt?

The image below, which you can click on for greater detail, shows that Central China Real Estate had debt of CN¥25.8b at the end of June 2022, a reduction from CN¥28.5b over a year. On the flip side, it has CN¥6.87b in cash leading to net debt of about CN¥18.9b.

A Look At Central China Real Estate's Liabilities

We can see from the most recent balance sheet that Central China Real Estate had liabilities of CN¥123.4b falling due within a year, and liabilities of CN¥16.3b due beyond that. Offsetting this, it had CN¥6.87b in cash and CN¥9.33b in receivables that were due within 12 months. So its liabilities total CN¥123.5b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥983.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Central China Real Estate would probably need a major re-capitalization if its creditors were to demand repayment. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Over 12 months, Central China Real Estate made a loss at the EBIT level, and saw its revenue drop to CN¥29b, which is a fall of 43%. To be frank that doesn't bode well.

Caveat Emptor

Not only did Central China Real Estate's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping CN¥2.3b. Reflecting on this and the significant total liabilities, it's hard to know what to say about the stock because of our intense dis-affinity for it. Like every long-shot we're sure it has a glossy presentation outlining its blue-sky potential. But the reality is that it is low on liquid assets relative to liabilities, and it lost CN¥5.7b in the last year. So we're not very excited about owning this stock. Its too risky for us. 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. We've identified 3 warning signs with Central China Real Estate (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.