Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies MTR Corporation Limited (HKG:66) makes use of debt. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

What Is MTR's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 MTR had HK$70.7b of debt, an increase on HK$53.5b, over one year. However, it also had HK$24.8b in cash, and so its net debt is HK$45.9b.

How Strong Is MTR's Balance Sheet?

The latest balance sheet data shows that MTR had liabilities of HK$28.7b due within a year, and liabilities of HK$153.3b falling due after that. Offsetting this, it had HK$24.8b in cash and HK$20.6b in receivables that were due within 12 months. So its liabilities total HK$136.6b more than the combination of its cash and short-term receivables.

This is a mountain of leverage even relative to its gargantuan market capitalization of HK$169.6b. 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).

MTR has a debt to EBITDA ratio of 2.6, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 12.4 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that MTR's EBIT shot up like bamboo after rain, gaining 64% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine MTR'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, MTR 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

We feel some trepidation about MTR's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that MTR is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. We've identified 1 warning sign with MTR , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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