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. We note that Dalian Port (PDA) Company Limited (HKG:2880) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Dalian Port (PDA)'s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Dalian Port (PDA) had CN¥11.1b of debt in March 2019, down from CN¥12.2b, one year before. However, it does have CN¥6.79b in cash offsetting this, leading to net debt of about CN¥4.29b.
How Healthy Is Dalian Port (PDA)'s Balance Sheet?
The latest balance sheet data shows that Dalian Port (PDA) had liabilities of CN¥4.56b due within a year, and liabilities of CN¥13.1b falling due after that. Offsetting this, it had CN¥6.79b in cash and CN¥1.91b in receivables that were due within 12 months. So it has liabilities totalling CN¥8.97b more than its cash and near-term receivables, combined.
Dalian Port (PDA) has a market capitalization of CN¥20.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Dalian Port (PDA)'s net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 5.4 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Also relevant is that Dalian Port (PDA) has grown its EBIT by a very respectable 27% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Dalian Port (PDA)'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Dalian Port (PDA) actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, Dalian Port (PDA)'s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. We would also note that Infrastructure industry companies like Dalian Port (PDA) commonly do use debt without problems. Taking all this data into account, it seems to us that Dalian Port (PDA) takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Over time, share prices tend to follow earnings per share, so if you're interested in Dalian Port (PDA), you may well want to click here to check an interactive graph of its earnings per share history.
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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