Here's Why Sinopec Oilfield Service (HKG:1033) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Sinopec Oilfield Service Corporation (HKG:1033) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sinopec Oilfield Service

How Much Debt Does Sinopec Oilfield Service Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Sinopec Oilfield Service had debt of CN¥21.2b, up from CN¥20.0b in one year. However, it does have CN¥3.81b in cash offsetting this, leading to net debt of about CN¥17.3b.

How Strong Is Sinopec Oilfield Service's Balance Sheet?

The latest balance sheet data shows that Sinopec Oilfield Service had liabilities of CN¥63.7b due within a year, and liabilities of CN¥1.08b falling due after that. Offsetting these obligations, it had cash of CN¥3.81b as well as receivables valued at CN¥30.4b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥30.6b.

This deficit is considerable relative to its market capitalization of CN¥32.7b, so it does suggest shareholders should keep an eye on Sinopec Oilfield Service's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Sinopec Oilfield Service's debt to EBITDA ratio (3.6) suggests that it uses some debt, its interest cover is very weak, at 2.0, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Sinopec Oilfield Service actually grew its EBIT by a hefty 105%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sinopec Oilfield Service'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Sinopec Oilfield Service actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Sinopec Oilfield Service's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Sinopec Oilfield Service's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Sinopec Oilfield Service .

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.