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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China State Construction Development Holdings Limited (HKG:830) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does China State Construction Development Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that China State Construction Development Holdings had HK$1.19b of debt in December 2023, down from HK$1.33b, one year before. On the flip side, it has HK$999.5m in cash leading to net debt of about HK$188.5m.

How Healthy Is China State Construction Development Holdings' Balance Sheet?

We can see from the most recent balance sheet that China State Construction Development Holdings had liabilities of HK$7.32b falling due within a year, and liabilities of HK$1.03b due beyond that. Offsetting this, it had HK$999.5m in cash and HK$7.41b in receivables that were due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to China State Construction Development Holdings' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the HK$5.64b company is short on cash, but still worth keeping an eye on the balance sheet.

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). 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).

China State Construction Development Holdings has net debt of just 0.21 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 10.0 times, which is more than adequate. In addition to that, we're happy to report that China State Construction Development Holdings has boosted its EBIT by 38%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China State Construction Development Holdings 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China State Construction Development Holdings reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

The good news is that China State Construction Development Holdings's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think China State Construction Development Holdings's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for China State Construction Development Holdings that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.