Here's Why China Petroleum Engineering (SHSE:600339) Can Manage Its Debt Responsibly

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 Engineering Corporation (SHSE:600339) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Petroleum Engineering

What Is China Petroleum Engineering's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 China Petroleum Engineering had CN¥4.00b of debt, an increase on CN¥2.00b, over one year. But it also has CN¥27.8b in cash to offset that, meaning it has CN¥23.8b net cash.

How Strong Is China Petroleum Engineering's Balance Sheet?

We can see from the most recent balance sheet that China Petroleum Engineering had liabilities of CN¥77.5b falling due within a year, and liabilities of CN¥5.87b due beyond that. On the other hand, it had cash of CN¥27.8b and CN¥47.0b worth of receivables due within a year. So it has liabilities totalling CN¥8.49b more than its cash and near-term receivables, combined.

China Petroleum Engineering has a market capitalization of CN¥20.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, China Petroleum Engineering boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that China Petroleum Engineering's load is not too heavy, because its EBIT was down 25% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Petroleum Engineering's ability to maintain a healthy balance sheet going forward. 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. China Petroleum Engineering 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. During the last three years, China Petroleum Engineering generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

Although China Petroleum Engineering's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥23.8b. The cherry on top was that in converted 94% of that EBIT to free cash flow, bringing in CN¥5.0b. So we are not troubled with China Petroleum Engineering's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with China Petroleum Engineering .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.