Is SINOPEC Engineering (Group) (HKG:2386) Using Too Much 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. We can see that SINOPEC Engineering (Group) Co., Ltd. (HKG:2386) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for SINOPEC Engineering (Group)

How Much Debt Does SINOPEC Engineering (Group) Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 SINOPEC Engineering (Group) had CN¥142.0m of debt, an increase on CN¥63.8m, over one year. But it also has CN¥24.0b in cash to offset that, meaning it has CN¥23.9b net cash.

How Strong Is SINOPEC Engineering (Group)'s Balance Sheet?

According to the last reported balance sheet, SINOPEC Engineering (Group) had liabilities of CN¥46.5b due within 12 months, and liabilities of CN¥2.17b due beyond 12 months. On the other hand, it had cash of CN¥24.0b and CN¥39.6b worth of receivables due within a year. So it actually has CN¥15.0b more liquid assets than total liabilities.

This excess liquidity is a great indication that SINOPEC Engineering (Group)'s balance sheet is almost as strong as Fort Knox. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that SINOPEC Engineering (Group) has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that SINOPEC Engineering (Group) saw its EBIT decline by 9.1% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if SINOPEC Engineering (Group) 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. SINOPEC Engineering (Group) 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. Over the last three years, SINOPEC Engineering (Group) actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to investigate a company's debt, in this case SINOPEC Engineering (Group) has CN¥23.9b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 202% of that EBIT to free cash flow, bringing in CN¥6.1b. So we don't think SINOPEC Engineering (Group)'s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with SINOPEC Engineering (Group) , and understanding them should be part of your investment process.

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.