Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Rongan Property Co.,Ltd. (SZSE:000517) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Rongan PropertyLtd

What Is Rongan PropertyLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Rongan PropertyLtd had CN¥8.87b of debt in March 2023, down from CN¥17.3b, one year before. However, it also had CN¥6.81b in cash, and so its net debt is CN¥2.06b.

How Strong Is Rongan PropertyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rongan PropertyLtd had liabilities of CN¥49.6b due within 12 months and liabilities of CN¥6.35b due beyond that. Offsetting these obligations, it had cash of CN¥6.81b as well as receivables valued at CN¥1.45b due within 12 months. So it has liabilities totalling CN¥47.7b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥10.4b 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, Rongan PropertyLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Rongan PropertyLtd has a fairly concerning net debt to EBITDA ratio of 33.0 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 Rongan PropertyLtd's EBIT was down 99% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Rongan PropertyLtd 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Rongan PropertyLtd's free cash flow amounted to 20% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Rongan PropertyLtd's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Rongan PropertyLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 example - Rongan PropertyLtd has 2 warning signs we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.