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 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. As with many other companies COSCO SHIPPING Ports Limited (HKG:1199) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 think about a company’s use of debt, we first look at cash and debt together.
What Is COSCO SHIPPING Ports’s Debt?
As you can see below, COSCO SHIPPING Ports had US$2.54b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had US$562.9m in cash, and so its net debt is US$1.98b.
How Healthy Is COSCO SHIPPING Ports’s Balance Sheet?
The latest balance sheet data shows that COSCO SHIPPING Ports had liabilities of US$774.5m due within a year, and liabilities of US$3.14b falling due after that. Offsetting these obligations, it had cash of US$562.9m as well as receivables valued at US$265.5m due within 12 months. So it has liabilities totalling US$3.08b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$2.92b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). 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).
With a net debt to EBITDA ratio of 5.5, it’s fair to say COSCO SHIPPING Ports does have a significant amount of debt. However, its interest coverage of 3.3 is reasonably strong, which is a good sign. The good news is that COSCO SHIPPING Ports grew its EBIT a smooth 58% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, COSCO SHIPPING Ports recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
To be frank both COSCO SHIPPING Ports’s conversion of EBIT to free cash flow and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like COSCO SHIPPING Ports commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making COSCO SHIPPING Ports stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if COSCO SHIPPING Ports insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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