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. We note that COSCO SHIPPING International (Hong Kong) Co., Ltd. (HKG:517) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does COSCO SHIPPING International (Hong Kong) Carry?
The image below, which you can click on for greater detail, shows that at December 2019 COSCO SHIPPING International (Hong Kong) had debt of HK$61.4m, up from HK$45.7m in one year. However, it does have HK$6.31b in cash offsetting this, leading to net cash of HK$6.25b.
How Healthy Is COSCO SHIPPING International (Hong Kong)'s Balance Sheet?
According to the last reported balance sheet, COSCO SHIPPING International (Hong Kong) had liabilities of HK$1.09b due within 12 months, and liabilities of HK$69.7m due beyond 12 months. Offsetting these obligations, it had cash of HK$6.31b as well as receivables valued at HK$1.50b due within 12 months. So it actually has HK$6.65b more liquid assets than total liabilities.
This surplus strongly suggests that COSCO SHIPPING International (Hong Kong) has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that COSCO SHIPPING International (Hong Kong) has more cash than debt is arguably a good indication that it can manage its debt safely.
But the bad news is that COSCO SHIPPING International (Hong Kong) has seen its EBIT plunge 10% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is COSCO SHIPPING International (Hong Kong)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While COSCO SHIPPING International (Hong Kong) has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, COSCO SHIPPING International (Hong Kong) 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.
While we empathize with investors who find debt concerning, the bottom line is that COSCO SHIPPING International (Hong Kong) has net cash of HK$6.25b and plenty of liquid assets. So we are not troubled with COSCO SHIPPING International (Hong Kong)'s debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with COSCO SHIPPING International (Hong Kong) (including 1 which is can't be ignored) .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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