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 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, COSCO SHIPPING Ports Limited (HKG:1199) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for COSCO SHIPPING Ports

How Much Debt Does COSCO SHIPPING Ports Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 COSCO SHIPPING Ports had US$3.32b of debt, an increase on US$3.01b, over one year. However, it also had US$1.24b in cash, and so its net debt is US$2.08b.

How Healthy Is COSCO SHIPPING Ports' Balance Sheet?

According to the last reported balance sheet, COSCO SHIPPING Ports had liabilities of US$1.74b due within 12 months, and liabilities of US$3.47b due beyond 12 months. Offsetting this, it had US$1.24b in cash and US$282.4m in receivables that were due within 12 months. So it has liabilities totalling US$3.69b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$2.48b, 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).

While COSCO SHIPPING Ports's debt to EBITDA ratio (5.0) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that COSCO SHIPPING Ports actually grew its EBIT by a hefty 203%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. 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 COSCO SHIPPING Ports's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. 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's not great, when it comes to paying down debt.

Our View

To be frank both COSCO SHIPPING Ports's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like COSCO SHIPPING Ports commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making COSCO SHIPPING Ports stock 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. 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. Case in point: We've spotted 2 warning signs for COSCO SHIPPING Ports 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.

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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.