Cathay Real Estate DevelopmentLtd (TPE:2501) 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.' 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. As with many other companies Cathay Real Estate Development Co.,Ltd. (TPE:2501) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. 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

What Is Cathay Real Estate DevelopmentLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Cathay Real Estate DevelopmentLtd had debt of NT$21.4b, up from NT$19.4b in one year. However, it does have NT$5.83b in cash offsetting this, leading to net debt of about NT$15.5b.

How Strong Is Cathay Real Estate DevelopmentLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cathay Real Estate DevelopmentLtd had liabilities of NT$23.2b due within 12 months and liabilities of NT$10.9b due beyond that. Offsetting this, it had NT$5.83b in cash and NT$534.5m in receivables that were due within 12 months. So it has liabilities totalling NT$27.7b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of NT$24.9b, we think shareholders really should watch Cathay Real Estate DevelopmentLtd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

As it happens Cathay Real Estate DevelopmentLtd has a fairly concerning net debt to EBITDA ratio of 7.6 but very strong interest coverage of 15.7. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Cathay Real Estate DevelopmentLtd grew its EBIT by 3.6% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Cathay Real Estate DevelopmentLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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 most recent three years, Cathay Real Estate DevelopmentLtd recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We feel some trepidation about Cathay Real Estate DevelopmentLtd's difficulty net debt to EBITDA, but we've got positives to focus on, too. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. We think that Cathay Real Estate DevelopmentLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Cathay Real Estate DevelopmentLtd (2 are a bit concerning) you should be aware of.

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.

When trading stocks or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.