We Think SINOPEC Engineering (Group) (HKG:2386) Can Manage Its Debt With Ease

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. 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?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

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How Much Debt Does SINOPEC Engineering (Group) Carry?

You can click the graphic below for the historical numbers, but it shows that SINOPEC Engineering (Group) had CN¥134.2m of debt in June 2022, down from CN¥174.6m, one year before. But on the other hand it also has CN¥17.4b in cash, leading to a CN¥17.3b net cash position.

A Look At SINOPEC Engineering (Group)'s Liabilities

We can see from the most recent balance sheet that SINOPEC Engineering (Group) had liabilities of CN¥40.4b falling due within a year, and liabilities of CN¥2.35b due beyond that. Offsetting this, it had CN¥17.4b in cash and CN¥40.3b in receivables that were due within 12 months. So it actually has CN¥15.0b more liquid assets than total liabilities.

This luscious liquidity implies that SINOPEC Engineering (Group)'s balance sheet is sturdy like a giant sequoia tree. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. 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.

It is just as well that SINOPEC Engineering (Group)'s load is not too heavy, because its EBIT was down 31% 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 SINOPEC Engineering (Group)'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While SINOPEC Engineering (Group) has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, SINOPEC Engineering (Group) actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While we empathize with investors who find debt concerning, the bottom line is that SINOPEC Engineering (Group) has net cash of CN¥17.3b and plenty of liquid assets. The cherry on top was that in converted 139% of that EBIT to free cash flow, bringing in CN¥2.7b. So we don't think SINOPEC Engineering (Group)'s use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that SINOPEC Engineering (Group) is showing 1 warning sign in our investment analysis , you should know about...

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.