Zhongman Petroleum and Natural Gas GroupLtd (SHSE:603619) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Zhongman Petroleum and Natural Gas GroupLtd

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

The image below, which you can click on for greater detail, shows that at March 2024 Zhongman Petroleum and Natural Gas GroupLtd had debt of CN¥3.38b, up from CN¥1.82b in one year. However, it also had CN¥1.17b in cash, and so its net debt is CN¥2.21b.

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

According to the last reported balance sheet, Zhongman Petroleum and Natural Gas GroupLtd had liabilities of CN¥4.26b due within 12 months, and liabilities of CN¥2.15b due beyond 12 months. Offsetting this, it had CN¥1.17b in cash and CN¥1.03b in receivables that were due within 12 months. So its liabilities total CN¥4.20b more than the combination of its cash and short-term receivables.

Zhongman Petroleum and Natural Gas GroupLtd has a market capitalization of CN¥9.36b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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 a debt to EBITDA ratio of 1.5, Zhongman Petroleum and Natural Gas GroupLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.8 times interest expense) certainly does not do anything to dispel this impression. The good news is that Zhongman Petroleum and Natural Gas GroupLtd has increased its EBIT by 8.5% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhongman Petroleum and Natural Gas GroupLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhongman Petroleum and Natural Gas GroupLtd recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Zhongman Petroleum and Natural Gas GroupLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest cover is relatively strong. We think that Zhongman Petroleum and Natural Gas GroupLtd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Zhongman Petroleum and Natural Gas GroupLtd has 2 warning signs we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

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