Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 CNOOC Limited (HKG:883) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does CNOOC Carry?
As you can see below, at the end of December 2018, CNOOC had CN¥139.5b of debt, up from CN¥132.3b a year ago. Click the image for more detail. But on the other hand it also has CN¥153.5b in cash, leading to a CN¥14.0b net cash position.
How Strong Is CNOOC's Balance Sheet?
According to the last reported balance sheet, CNOOC had liabilities of CN¥70.2b due within 12 months, and liabilities of CN¥191.2b due beyond 12 months. Offsetting these obligations, it had cash of CN¥153.5b as well as receivables valued at CN¥23.3b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥84.7b.
Of course, CNOOC has a titanic market capitalization of CN¥489.1b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, CNOOC boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, CNOOC grew its EBIT by 121% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine CNOOC's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. CNOOC may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, CNOOC actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While CNOOC does have more liabilities than liquid assets, it also has net cash of CN¥14b. And it impressed us with free cash flow of CN¥73b, being 106% of its EBIT. So we don't think CNOOC's use of debt is risky. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check CNOOC's dividend history, without delay!
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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