Is Sinopec Oilfield Service (HKG:1033) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, 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.

View our latest analysis for Sinopec Oilfield Service

What Is Sinopec Oilfield Service's Debt?

The chart below, which you can click on for greater detail, shows that Sinopec Oilfield Service had CN¥21.2b in debt in September 2022; about the same as the year before. However, it does have CN¥1.72b in cash offsetting this, leading to net debt of about CN¥19.5b.

A Look At Sinopec Oilfield Service's Liabilities

The latest balance sheet data shows that Sinopec Oilfield Service had liabilities of CN¥58.0b due within a year, and liabilities of CN¥2.39b falling due after that. Offsetting these obligations, it had cash of CN¥1.72b as well as receivables valued at CN¥30.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥27.8b.

This deficit is considerable relative to its market capitalization of CN¥32.1b, 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 5.0 hit our confidence in Sinopec Oilfield Service like a one-two punch to the gut. The debt burden here is substantial. However, one redeeming factor is that Sinopec Oilfield Service grew its EBIT at 10% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sinopec Oilfield Service 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Sinopec Oilfield Service recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Sinopec Oilfield Service's net debt to EBITDA makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Sinopec Oilfield Service is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For instance, we've identified 2 warning signs for Sinopec Oilfield Service (1 doesn't sit too well with us) you should be aware of.

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.