Here's Why Sinopec Oilfield Service (HKG:1033) Is Weighed Down By Its Debt Load

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Sinopec Oilfield Service Corporation (HKG:1033) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

Check out our latest analysis for Sinopec Oilfield Service

What Is Sinopec Oilfield Service's Debt?

You can click the graphic below for the historical numbers, but it shows that Sinopec Oilfield Service had CN¥21.4b of debt in September 2021, down from CN¥22.3b, one year before. On the flip side, it has CN¥1.35b in cash leading to net debt of about CN¥20.1b.

How Strong Is Sinopec Oilfield Service's Balance Sheet?

The latest balance sheet data shows that Sinopec Oilfield Service had liabilities of CN¥54.5b due within a year, and liabilities of CN¥1.80b falling due after that. Offsetting this, it had CN¥1.35b in cash and CN¥29.5b in receivables that were due within 12 months. So it has liabilities totalling CN¥25.4b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥32.4b, 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). 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).

Sinopec Oilfield Service shareholders face the double whammy of a high net debt to EBITDA ratio (5.7), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. The debt burden here is substantial. Even worse, Sinopec Oilfield Service saw its EBIT tank 46% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Sinopec Oilfield Service'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Sinopec Oilfield Service actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Sinopec Oilfield Service's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Sinopec Oilfield Service has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 3 warning signs for Sinopec Oilfield Service (1 is potentially serious!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.