COSCO SHIPPING Ports (HKG:1199) Takes On Some Risk With Its Use Of Debt

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. We note that COSCO SHIPPING Ports Limited (HKG:1199) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that 1199 is potentially undervalued!

What Is COSCO SHIPPING Ports's Net Debt?

The chart below, which you can click on for greater detail, shows that COSCO SHIPPING Ports had US$3.04b in debt in September 2022; about the same as the year before. On the flip side, it has US$1.21b in cash leading to net debt of about US$1.83b.

A Look At COSCO SHIPPING Ports' Liabilities

According to the last reported balance sheet, COSCO SHIPPING Ports had liabilities of US$1.62b due within 12 months, and liabilities of US$3.21b due beyond 12 months. On the other hand, it had cash of US$1.21b and US$261.0m worth of receivables due within a year. So its liabilities total US$3.35b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$2.67b, we think shareholders really should watch COSCO SHIPPING Ports's debt levels, like a parent watching their child ride a bike for the first time. 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 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).

COSCO SHIPPING Ports has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 2.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that COSCO SHIPPING Ports actually grew its EBIT by a hefty 146%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, COSCO SHIPPING Ports recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither COSCO SHIPPING Ports's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Infrastructure industry companies like COSCO SHIPPING Ports commonly do use debt without problems. When we consider all the factors discussed, it seems to us that COSCO SHIPPING Ports is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 2 warning signs for COSCO SHIPPING Ports (1 is a bit unpleasant!) that you should be aware of before investing here.

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.

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.