Does Hainan Meilan International Airport (HKG:357) Have A Healthy Balance Sheet?

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. Importantly, Hainan Meilan International Airport Company Limited (HKG:357) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hainan Meilan International Airport

What Is Hainan Meilan International Airport's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Hainan Meilan International Airport had CN¥2.35b of debt in June 2021, down from CN¥2.88b, one year before. However, because it has a cash reserve of CN¥551.0m, its net debt is less, at about CN¥1.80b.

A Look At Hainan Meilan International Airport's Liabilities

According to the last reported balance sheet, Hainan Meilan International Airport had liabilities of CN¥6.94b due within 12 months, and liabilities of CN¥329.2m due beyond 12 months. On the other hand, it had cash of CN¥551.0m and CN¥396.6m worth of receivables due within a year. So its liabilities total CN¥6.33b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥9.30b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hainan Meilan International Airport has a debt to EBITDA ratio of 2.7, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 22.7 is very high, suggesting that the interest expense on the debt is currently quite low. Sadly, Hainan Meilan International Airport's EBIT actually dropped 2.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hainan Meilan International Airport can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Hainan Meilan International Airport 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

We'd go so far as to say Hainan Meilan International Airport's conversion of EBIT to free cash flow was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like Hainan Meilan International Airport commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Hainan Meilan International Airport's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 - Hainan Meilan International Airport has 2 warning signs we think you should be aware of.

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.

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.