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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hutchison Port Holdings Trust (SGX:NS8U) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hutchison Port Holdings Trust

What Is Hutchison Port Holdings Trust's Net Debt?

As you can see below, Hutchison Port Holdings Trust had HK$27.3b of debt at June 2022, down from HK$29.1b a year prior. However, it does have HK$11.5b in cash offsetting this, leading to net debt of about HK$15.8b.

How Strong Is Hutchison Port Holdings Trust's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hutchison Port Holdings Trust had liabilities of HK$16.6b due within 12 months and liabilities of HK$27.1b due beyond that. On the other hand, it had cash of HK$11.5b and HK$4.23b worth of receivables due within a year. So its liabilities total HK$28.0b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$13.6b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Hutchison Port Holdings Trust would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 2.3, Hutchison Port Holdings Trust uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.7 times its interest expenses harmonizes with that theme. If Hutchison Port Holdings Trust can keep growing EBIT at last year's rate of 14% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hutchison Port Holdings Trust 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.

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. Happily for any shareholders, Hutchison Port Holdings Trust actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Hutchison Port Holdings Trust's level of total liabilities was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. We would also note that Infrastructure industry companies like Hutchison Port Holdings Trust commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Hutchison Port Holdings Trust's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Hutchison Port Holdings Trust (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.