ZongTai Real Estate Development (TPE:3056) Use Of Debt Could Be Considered Risky

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.' 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 can see that ZongTai Real Estate Development Co., Ltd. (TPE:3056) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for ZongTai Real Estate Development

What Is ZongTai Real Estate Development's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 ZongTai Real Estate Development had debt of NT$10.5b, up from NT$4.34b in one year. On the flip side, it has NT$2.59b in cash leading to net debt of about NT$7.91b.

A Look At ZongTai Real Estate Development's Liabilities

We can see from the most recent balance sheet that ZongTai Real Estate Development had liabilities of NT$11.8b falling due within a year, and liabilities of NT$2.26b due beyond that. Offsetting these obligations, it had cash of NT$2.59b as well as receivables valued at NT$11.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$11.5b.

When you consider that this deficiency exceeds the company's NT$8.35b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

As it happens ZongTai Real Estate Development has a fairly concerning net debt to EBITDA ratio of 25.1 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 ZongTai Real Estate Development's EBIT was down 25% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is ZongTai Real Estate Development'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, ZongTai Real Estate Development 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

On the face of it, ZongTai Real Estate Development's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate 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 ZongTai Real Estate Development has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Case in point: We've spotted 4 warning signs for ZongTai Real Estate Development you should be aware of, and 3 of them make us uncomfortable.

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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