The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Liaoning Port Co., Ltd. (HKG:2880) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Liaoning Port Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Liaoning Port had debt of CN¥7.58b, up from CN¥5.91b in one year. On the flip side, it has CN¥4.26b in cash leading to net debt of about CN¥3.32b.

How Strong Is Liaoning Port's Balance Sheet?

The latest balance sheet data shows that Liaoning Port had liabilities of CN¥5.89b due within a year, and liabilities of CN¥9.98b falling due after that. Offsetting these obligations, it had cash of CN¥4.26b as well as receivables valued at CN¥4.49b due within 12 months. So its liabilities total CN¥7.13b more than the combination of its cash and short-term receivables.

Liaoning Port has a market capitalization of CN¥34.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Liaoning Port's net debt is only 0.83 times its EBITDA. And its EBIT covers its interest expense a whopping 15.3 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Liaoning Port's EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Liaoning Port will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Liaoning Port's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Liaoning Port was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. It's also worth noting that Liaoning Port is in the Infrastructure industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Liaoning Port is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Liaoning Port you should know about.

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.

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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.