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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that China Merchants Port Group Co., Ltd. (SZSE:001872) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does China Merchants Port Group Carry?

The chart below, which you can click on for greater detail, shows that China Merchants Port Group had CN¥54.5b in debt in June 2024; about the same as the year before. However, because it has a cash reserve of CN¥20.6b, its net debt is less, at about CN¥33.9b.

A Look At China Merchants Port Group's Liabilities

We can see from the most recent balance sheet that China Merchants Port Group had liabilities of CN¥26.7b falling due within a year, and liabilities of CN¥47.1b due beyond that. Offsetting these obligations, it had cash of CN¥20.6b as well as receivables valued at CN¥3.35b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥49.9b.

This is a mountain of leverage relative to its market capitalization of CN¥51.4b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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 Merchants Port Group has a debt to EBITDA ratio of 4.7, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Notably China Merchants Port Group's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Merchants Port Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, China Merchants Port Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

China Merchants Port Group's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. But truth be told its net debt to EBITDA had us nibbling our nails. We would also note that Infrastructure industry companies like China Merchants Port Group commonly do use debt without problems. Looking at all this data makes us feel a little cautious about China Merchants Port Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 1 warning sign for China Merchants Port Group 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.