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.' 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 note that Yunnan Metropolitan RealEstate Development Co.Ltd (SHSE:600239) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Yunnan Metropolitan RealEstate DevelopmentLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Yunnan Metropolitan RealEstate DevelopmentLtd had CN¥4.66b of debt, an increase on CN¥3.43b, over one year. However, because it has a cash reserve of CN¥799.4m, its net debt is less, at about CN¥3.86b.

A Look At Yunnan Metropolitan RealEstate DevelopmentLtd's Liabilities

The latest balance sheet data shows that Yunnan Metropolitan RealEstate DevelopmentLtd had liabilities of CN¥3.48b due within a year, and liabilities of CN¥5.81b falling due after that. Offsetting this, it had CN¥799.4m in cash and CN¥785.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.71b.

This deficit casts a shadow over the CN¥4.77b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Yunnan Metropolitan RealEstate DevelopmentLtd 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.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 10.7 hit our confidence in Yunnan Metropolitan RealEstate DevelopmentLtd like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Yunnan Metropolitan RealEstate DevelopmentLtd is that it turned last year's EBIT loss into a gain of CN¥329m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Yunnan Metropolitan RealEstate DevelopmentLtd's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Yunnan Metropolitan RealEstate DevelopmentLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Yunnan Metropolitan RealEstate DevelopmentLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Considering all the factors previously mentioned, we think that Yunnan Metropolitan RealEstate DevelopmentLtd really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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, we've discovered 1 warning sign for Yunnan Metropolitan RealEstate DevelopmentLtd that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.