Here's Why COSCO SHIPPING Development (HKG:2866) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies COSCO SHIPPING Development Co., Ltd. (HKG:2866) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for COSCO SHIPPING Development

What Is COSCO SHIPPING Development's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 COSCO SHIPPING Development had CN¥90.7b of debt, an increase on CN¥86.4b, over one year. However, it does have CN¥14.4b in cash offsetting this, leading to net debt of about CN¥76.3b.

How Strong Is COSCO SHIPPING Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that COSCO SHIPPING Development had liabilities of CN¥56.1b due within 12 months and liabilities of CN¥47.8b due beyond that. Offsetting this, it had CN¥14.4b in cash and CN¥7.82b in receivables that were due within 12 months. So its liabilities total CN¥81.7b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥27.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, COSCO SHIPPING Development would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Strangely COSCO SHIPPING Development has a sky high EBITDA ratio of 7.6, implying high debt, but a strong interest coverage of 20.3. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We note that COSCO SHIPPING Development grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since COSCO SHIPPING Development will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, COSCO SHIPPING Development saw substantial negative free cash flow, in total. 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 conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider COSCO SHIPPING Development to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example COSCO SHIPPING Development has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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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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.