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.' 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 COSCO SHIPPING Ports Limited (HKG:1199) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is COSCO SHIPPING Ports's Net Debt?

As you can see below, COSCO SHIPPING Ports had US$3.16b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$995.4m in cash offsetting this, leading to net debt of about US$2.17b.

How Healthy Is COSCO SHIPPING Ports' Balance Sheet?

According to the last reported balance sheet, COSCO SHIPPING Ports had liabilities of US$1.73b due within 12 months, and liabilities of US$3.30b due beyond 12 months. Offsetting these obligations, it had cash of US$995.4m as well as receivables valued at US$338.4m due within 12 months. So its liabilities total US$3.69b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$2.56b, we think shareholders really should watch COSCO SHIPPING Ports's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

While we wouldn't worry about COSCO SHIPPING Ports's net debt to EBITDA ratio of 4.7, we think its super-low interest cover of 1.9 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. More concerning, COSCO SHIPPING Ports saw its EBIT drop by 4.2% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine COSCO SHIPPING Ports's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, COSCO SHIPPING Ports recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, COSCO SHIPPING Ports's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. We should also note that Infrastructure industry companies like COSCO SHIPPING Ports commonly do use debt without problems. Overall, it seems to us that COSCO SHIPPING Ports's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 2 warning signs for COSCO SHIPPING Ports you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com