We think China Petroleum & Chemical (HKG:386) is taking risks with its debt
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that China Petroleum and Chemical Company (HKG:386) 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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.
See our latest analysis for China Petroleum & Chemical
What is China Petroleum & Chemical’s debt?
You can click on the graph below for historical figures, but it shows that in March 2022, China Petroleum & Chemical had a debt of 194.3 billion Canadian yen, an increase from 169.5 billion yen Canadians, over one year. However, he has 188.3 billion Canadian yen in cash to offset this, resulting in a net debt of approximately 6.03 billion Canadian yen.
How strong is China Petroleum & Chemical’s balance sheet?
According to the latest published balance sheet, China Petroleum & Chemical had liabilities of 730.0 billion Canadian yen due within 12 months and liabilities of 349.3 billion Canadian yen due beyond 12 months. On the other hand, it had liquid assets of 188.3 billion Canadian yen and 84.0 billion national yen of receivables due within one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of 806.9 billion Canadian yen.
The deficiency here weighs heavily on the CN¥470.1b business itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. We would therefore be watching his balance sheet closely, no doubt. Ultimately, China Petroleum & Chemical would likely need a major recapitalization if its creditors demanded repayment. China Petroleum & Chemical may have virtually no net debt, but it has a lot of liabilities.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
With debt at a measly 0.027 times EBITDA and an EBIT covering interest of 57.4 times, it is clear that China Petroleum & Chemical is not a desperate borrower. Indeed, relative to its earnings, its leverage seems light as a feather. On top of that, China Petroleum & Chemical has increased its EBIT by 75% in the last twelve months, and this growth will make it easier to manage its debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether China Petroleum & Chemical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, China Petroleum & Chemical has recorded free cash flow of 39% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
While the level of China Petroleum & Chemical’s total liabilities makes us nervous. For example, its interest coverage and EBIT growth rate give us some confidence in its ability to manage its debt. From all the angles mentioned above, it seems to us that China Petroleum & Chemical is a bit of a risky investment due to its leverage. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 2 warning signs for China Petroleum & Chemical (1 is a little worrying) you should be aware.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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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.