We Think New World Department Store China (HKG:825) Is Taking Some Risk With Its 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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that New World Department Store China Limited (HKG:825) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 New World Department Store China

What Is New World Department Store China's Debt?

You can click the graphic below for the historical numbers, but it shows that New World Department Store China had HK$1.41b of debt in December 2019, down from HK$1.88b, one year before. However, it does have HK$2.02b in cash offsetting this, leading to net cash of HK$612.1m.

A Look At New World Department Store China's Liabilities

Zooming in on the latest balance sheet data, we can see that New World Department Store China had liabilities of HK$4.83b due within 12 months and liabilities of HK$4.51b due beyond that. On the other hand, it had cash of HK$2.02b and HK$134.7m worth of receivables due within a year. So it has liabilities totalling HK$7.18b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$2.53b 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 definitely think shareholders need to watch this one closely. At the end of the day, New World Department Store China would probably need a major re-capitalization if its creditors were to demand repayment. New World Department Store China boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

If New World Department Store China can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since New World Department Store China will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While New World Department Store China has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, New World Department Store China's free cash flow amounted to 21% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

Although New World Department Store China's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$612.1m. And we liked the look of last year's 16% year-on-year EBIT growth. Despite the cash, we do find New World Department Store China's level of total liabilities concerning, so we're not particularly comfortable with the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for New World Department Store China you should be aware of, and 1 of them 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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