Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Liaoning Port Co., Ltd. (HKG:2880) uses debt in his business. But the real question is whether this debt makes the business risky.
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Liaoning Port
How much debt does Liaoning Port carry?
The image below, which you can click for more details, shows that Liaoning Port had a debt of 4.91 billion yen at the end of March 2022, a reduction from 7.51 billion yen over one year. However, it has 4.75 billion national yen of cash to offset this, resulting in a net debt of approximately 164.6 million national yen.
How strong is Liaoning Port’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Liaoning Port had liabilities of 7.54 billion Canadian yen due within 12 months and liabilities of 10.00 billion domestic yen due beyond. In return, he had 4.75 billion yen in cash and 4.04 billion yen in debt due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of 8.75 billion Canadian yen.
The port of Liaoning has a market capitalization of 31.8 billion Canadian yen, so it could very likely raise funds to improve its balance sheet, should the need arise. But it is clear that it must be carefully examined whether he can manage his debt without dilution. Carrying virtually no net debt, the port of Liaoning indeed has a very light debt.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without depreciation and amortization charges.
With debt at a measly 0.035 times EBITDA and EBIT covering interest at 23.0 times, it’s clear that Liaoning Port is not a desperate borrower. Thus, compared to previous income, the level of indebtedness seems insignificant. On the other hand, Liaoning Port’s EBIT fell 20% over the past year. If this rate of decline in profits continues, the company could find itself in a difficult situation. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in total isolation; since Liaoning Port will need revenue to repay this debt. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Liaoning Port has had free cash flow of 62% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
The ability of the port of Liaoning to cover its interest charges with its EBIT and its net debt to EBITDA has reinforced our ability to manage its debt. But truth be told, its EBIT growth rate had us biting our nails. It should also be noted that Liaoning Port belongs to the infrastructure sector, which is often considered quite defensive. Given this range of data points, we believe Liaoning Port is in a good position to manage its level of indebtedness. But be warned: we believe debt levels are high enough to warrant continued monitoring. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for Liaoning Port you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.