Is COSCO SHIPPING Development (HKG:2866) A Risky Investment?

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.' 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 should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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

What Is COSCO SHIPPING Development's Debt?

The image below, which you can click on for greater detail, shows that COSCO SHIPPING Development had debt of CN¥87.0b at the end of March 2022, a reduction from CN¥111.4b over a year. However, it does have CN¥17.9b in cash offsetting this, leading to net debt of about CN¥69.1b.

How Healthy 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¥53.5b due within 12 months and liabilities of CN¥45.8b due beyond that. Offsetting these obligations, it had cash of CN¥17.9b as well as receivables valued at CN¥6.42b due within 12 months. So it has liabilities totalling CN¥74.9b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥35.0b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, COSCO SHIPPING Development would probably need a major re-capitalization if its creditors were to demand repayment.

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

As it happens COSCO SHIPPING Development has a fairly concerning net debt to EBITDA ratio of 6.0 but very strong interest coverage of 173. So either it has access to very cheap long term debt or that interest expense is going to grow! Pleasingly, COSCO SHIPPING Development is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 148% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is COSCO SHIPPING Development's earnings that will influence how the balance sheet holds up in the future. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding 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 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. Overall, we think it's fair to say that COSCO SHIPPING Development has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we've spotted with COSCO SHIPPING Development .

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.