Does COSCO SHIPPING Energy Transportation (HKG:1138) have a healthy balance sheet?

Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that COSCO SHIPPING Energy Transportation Co., Ltd. (HKG:1138) has a debt on its balance sheet. But should shareholders worry about its use of debt?

When is debt dangerous?

Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.

Check out our latest analysis for COSCO SHIPPING Energy Transportation

What is COSCO SHIPPING Energy Transportation’s debt?

The graph below, which you can click on for more details, shows that COSCO SHIPPING Energy Transportation had a debt of 23.4 billion yen in December 2021; about the same as the previous year. However, he also had 3.52 billion Canadian yen in cash, so his net debt is 19.9 billion domestic yen.

SEHK: 1138 Historical Debt to Equity May 2, 2022

How strong is COSCO SHIPPING Energy Transportation’s balance sheet?

We can see from the most recent balance sheet that COSCO SHIPPING Energy Transportation had liabilities of 13.3 billion yen due in one year, and liabilities of 16.1 billion yen due beyond. In compensation for these obligations, it had cash of 3.52 billion yen as well as receivables valued at 1.41 billion yen due within 12 months. It therefore has liabilities totaling 24.5 billion Canadian yen more than its cash and short-term receivables, combined.

This deficit is considerable compared to its market capitalization of 31.9 billion Canadian yen, so it suggests that shareholders monitor the use of debt by COSCO SHIPPING Energy Transportation. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.

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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

In this case, COSCO SHIPPING Energy Transportation has a rather concerning net debt to EBITDA ratio of 7.1, but very high interest coverage of 1k. This means that unless the company has access to very cheap debt, these interest charges will likely increase in the future. Importantly, COSCO SHIPPING Energy Transportation’s EBIT has fallen by 94% in the last twelve months. If this earnings trend continues, paying off debt will be about as easy as herding cats on a roller coaster. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine COSCO SHIPPING Energy Transportation’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a company can only repay its debts with cold hard cash, not with book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Fortunately for all shareholders, COSCO SHIPPING Energy Transportation has actually produced more free cash flow than EBIT for the past three years. There’s nothing better than incoming money to stay in the good books of your lenders.

Our point of view

We feel some apprehension about COSCO SHIPPING Energy Transportation’s challenging EBIT growth rate, but we also have some positives to focus on. Interest coverage and the conversion of EBIT to free cash flow were encouraging signs. Considering the above factors, we believe COSCO SHIPPING Energy Transportation’s debt poses certain risks to the business. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. 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. We have identified 2 warning signs with COSCO SHIPPING Energy Transportation (at least 1 that should not be ignored), and understanding them should be part of your investment process.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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.

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