MTR (HKG:66) Has A Somewhat Strained Balance Sheet

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.' 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 can see that MTR Corporation Limited (HKG:66) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for MTR

What Is MTR's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 MTR had debt of HK$70.7b, up from HK$53.5b in one year. On the flip side, it has HK$24.8b in cash leading to net debt of about HK$45.9b.

How Healthy Is MTR's Balance Sheet?

According to the last reported balance sheet, MTR had liabilities of HK$28.7b due within 12 months, and liabilities of HK$153.3b due beyond 12 months. Offsetting these obligations, it had cash of HK$24.8b as well as receivables valued at HK$20.6b due within 12 months. So it has liabilities totalling HK$136.6b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of HK$169.3b, so it does suggest shareholders should keep an eye on MTR's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

MTR's net debt is 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 12.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, MTR grew its EBIT by 64% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if MTR 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, MTR 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

While MTR's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We think that MTR's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example, we've discovered 1 warning sign for MTR that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.