The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that China Petroleum & Chemical Corporation (HKG:386) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Petroleum & Chemical Carry?
The chart below, which you can click on for greater detail, shows that China Petroleum & Chemical had CN¥192.2b in debt in June 2019; about the same as the year before. On the flip side, it has CN¥182.7b in cash leading to net debt of about CN¥9.51b.
How Healthy Is China Petroleum & Chemical's Balance Sheet?
We can see from the most recent balance sheet that China Petroleum & Chemical had liabilities of CN¥605.4b falling due within a year, and liabilities of CN¥352.2b due beyond that. Offsetting these obligations, it had cash of CN¥182.7b as well as receivables valued at CN¥79.4b due within 12 months. So it has liabilities totalling CN¥695.5b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of CN¥584.5b, we think shareholders really should watch China Petroleum & Chemical's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With debt at a measly 0.056 times EBITDA and EBIT covering interest a whopping 22.7 times, it's clear that China Petroleum & Chemical is not a desperate borrower. So relative to past earnings, the debt load seems trivial. In fact China Petroleum & Chemical's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Petroleum & Chemical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Happily for any shareholders, China Petroleum & Chemical actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
We feel some trepidation about China Petroleum & Chemical's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. Looking at all the angles mentioned above, it does seem to us that China Petroleum & Chemical is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given China Petroleum & Chemical has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.