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. As with many other companies Xinghua Port Holdings Ltd. (HKG:1990) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Xinghua Port Holdings Carry?
The image below, which you can click on for greater detail, shows that Xinghua Port Holdings had debt of CN¥547.4m at the end of June 2019, a reduction from CN¥629.4m over a year. However, because it has a cash reserve of CN¥107.2m, its net debt is less, at about CN¥440.2m.
A Look At Xinghua Port Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that Xinghua Port Holdings had liabilities of CN¥162.4m due within 12 months and liabilities of CN¥539.1m due beyond that. On the other hand, it had cash of CN¥107.2m and CN¥80.4m worth of receivables due within a year. So it has liabilities totalling CN¥514.0m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CN¥831.3m, so it does suggest shareholders should keep an eye on Xinghua Port Holdings's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
Xinghua Port Holdings has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.9 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Shareholders should be aware that Xinghua Port Holdings's EBIT was down 25% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Xinghua Port Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Xinghua Port Holdings produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
We'd go so far as to say Xinghua Port Holdings's EBIT growth rate was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. It's also worth noting that Xinghua Port Holdings is in the Infrastructure industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Xinghua Port Holdings 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. Given our hesitation about the stock, it would be good to know if Xinghua Port Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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