Here's Why Cathay Real Estate DevelopmentLtd (TWSE:2501) Has A Meaningful Debt Burden

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. We note that Cathay Real Estate Development Co.,Ltd. (TWSE:2501) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Cathay Real Estate DevelopmentLtd

How Much Debt Does Cathay Real Estate DevelopmentLtd Carry?

As you can see below, Cathay Real Estate DevelopmentLtd had NT$37.7b of debt at September 2023, down from NT$39.3b a year prior. However, it also had NT$8.27b in cash, and so its net debt is NT$29.4b.

A Look At Cathay Real Estate DevelopmentLtd's Liabilities

According to the last reported balance sheet, Cathay Real Estate DevelopmentLtd had liabilities of NT$27.7b due within 12 months, and liabilities of NT$26.0b due beyond 12 months. Offsetting this, it had NT$8.27b in cash and NT$973.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$44.5b.

This deficit casts a shadow over the NT$23.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Cathay Real Estate DevelopmentLtd would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 9.6, it's fair to say Cathay Real Estate DevelopmentLtd does have a significant amount of debt. However, its interest coverage of 6.9 is reasonably strong, which is a good sign. It is well worth noting that Cathay Real Estate DevelopmentLtd's EBIT shot up like bamboo after rain, gaining 71% in the last twelve months. That'll make it easier to manage its 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 Cathay Real Estate DevelopmentLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Cathay Real Estate DevelopmentLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Cathay Real Estate DevelopmentLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Cathay Real Estate DevelopmentLtd to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 Cathay Real Estate DevelopmentLtd (including 2 which make us uncomfortable) .

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. 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.