Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 China Merchants Port Holdings Company Limited (HKG:144) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for China Merchants Port Holdings

What Is China Merchants Port Holdings's Debt?

As you can see below, China Merchants Port Holdings had HK$35.1b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$8.86b in cash leading to net debt of about HK$26.2b.

How Healthy Is China Merchants Port Holdings' Balance Sheet?

According to the last reported balance sheet, China Merchants Port Holdings had liabilities of HK$17.7b due within 12 months, and liabilities of HK$36.0b due beyond 12 months. On the other hand, it had cash of HK$8.86b and HK$4.13b worth of receivables due within a year. So it has liabilities totalling HK$40.7b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$46.2b, so it does suggest shareholders should keep an eye on China Merchants Port Holdings' 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.

China Merchants Port Holdings's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, China Merchants Port Holdings grew its EBIT by 28% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Merchants Port Holdings'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Merchants Port Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

China Merchants Port Holdings's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. We would also note that Infrastructure industry companies like China Merchants Port Holdings commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that China Merchants Port Holdings is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. To that end, you should be aware of the 2 warning signs we've spotted with China Merchants Port Holdings .

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.

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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.