COSCO SHIPPING Development (HKG:2866) Use Of Debt Could Be Considered Risky

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 COSCO SHIPPING Development Co., Ltd. (HKG:2866) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for COSCO SHIPPING Development

How Much Debt Does COSCO SHIPPING Development Carry?

You can click the graphic below for the historical numbers, but it shows that COSCO SHIPPING Development had CN¥85.7b of debt in September 2023, down from CN¥93.6b, one year before. On the flip side, it has CN¥10.5b in cash leading to net debt of about CN¥75.2b.

How Healthy Is COSCO SHIPPING Development's Balance Sheet?

The latest balance sheet data shows that COSCO SHIPPING Development had liabilities of CN¥32.7b due within a year, and liabilities of CN¥59.1b falling due after that. Offsetting these obligations, it had cash of CN¥10.5b as well as receivables valued at CN¥4.43b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥76.9b.

This deficit casts a shadow over the CN¥26.0b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, COSCO SHIPPING Development would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 11.9 hit our confidence in COSCO SHIPPING Development like a one-two punch to the gut. The debt burden here is substantial. Even worse, COSCO SHIPPING Development saw its EBIT tank 38% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is COSCO SHIPPING Development's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last three years, COSCO SHIPPING Development burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both COSCO SHIPPING Development's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that COSCO SHIPPING Development is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for COSCO SHIPPING Development (of which 1 can't be ignored!) you should know about.

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.

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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.