Is Zhongman Petroleum and Natural Gas GroupLtd (SHSE:603619) A Risky Investment?

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Zhongman Petroleum and Natural Gas Group Corp.,Ltd. (SHSE:603619) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Zhongman Petroleum and Natural Gas GroupLtd

What Is Zhongman Petroleum and Natural Gas GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Zhongman Petroleum and Natural Gas GroupLtd had debt of CN¥3.75b, up from CN¥2.54b in one year. However, it does have CN¥2.30b in cash offsetting this, leading to net debt of about CN¥1.45b.

How Strong Is Zhongman Petroleum and Natural Gas GroupLtd's Balance Sheet?

The latest balance sheet data shows that Zhongman Petroleum and Natural Gas GroupLtd had liabilities of CN¥4.90b due within a year, and liabilities of CN¥1.82b falling due after that. On the other hand, it had cash of CN¥2.30b and CN¥1.13b worth of receivables due within a year. So its liabilities total CN¥3.30b more than the combination of its cash and short-term receivables.

Zhongman Petroleum and Natural Gas GroupLtd has a market capitalization of CN¥8.46b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt sitting at just 0.91 times EBITDA, Zhongman Petroleum and Natural Gas GroupLtd is arguably pretty conservatively geared. And it boasts interest cover of 7.8 times, which is more than adequate. Fortunately, Zhongman Petroleum and Natural Gas GroupLtd grew its EBIT by 4.5% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhongman Petroleum and Natural Gas GroupLtd can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Zhongman Petroleum and Natural Gas GroupLtd created free cash flow amounting to 10% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Even if we have reservations about how easily Zhongman Petroleum and Natural Gas GroupLtd is capable of converting EBIT to free cash flow, its net debt to EBITDA and interest cover make us think feel relatively unconcerned. Looking at all the angles mentioned above, it does seem to us that Zhongman Petroleum and Natural Gas GroupLtd 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Zhongman Petroleum and Natural Gas GroupLtd you should be aware of.

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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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.