Is Sinopec Oilfield Service (HKG:1033) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Sinopec Oilfield Service Corporation (HKG:1033) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Sinopec Oilfield Service

What Is Sinopec Oilfield Service's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Sinopec Oilfield Service had debt of CN¥21.8b, up from CN¥19.8b in one year. On the flip side, it has CN¥1.69b in cash leading to net debt of about CN¥20.1b.

A Look At Sinopec Oilfield Service's Liabilities

Zooming in on the latest balance sheet data, we can see that Sinopec Oilfield Service had liabilities of CN¥55.3b due within 12 months and liabilities of CN¥2.83b due beyond that. Offsetting these obligations, it had cash of CN¥1.69b as well as receivables valued at CN¥29.6b due within 12 months. So its liabilities total CN¥26.8b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥31.1b, so it does suggest shareholders should keep an eye on Sinopec Oilfield Service's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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 (4.4) suggests that it uses some debt, its interest cover is very weak, at 2.1, 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. Even more troubling is the fact that Sinopec Oilfield Service actually let its EBIT decrease by 3.5% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 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.

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. During the last two years, Sinopec Oilfield Service burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Sinopec Oilfield Service's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Sinopec Oilfield Service's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Sinopec Oilfield Service is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

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. 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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