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. We note that Sinopec Oilfield Service Corporation (HKG:1033) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Sinopec Oilfield Service Carry?
As you can see below, at the end of September 2020, Sinopec Oilfield Service had CN¥21.8b of debt, up from CN¥19.8b a year ago. Click the image for more detail. On the flip side, it has CN¥1.69b in cash leading to net debt of about CN¥20.1b.
How Strong Is Sinopec Oilfield Service's Balance Sheet?
According to the last reported balance sheet, Sinopec Oilfield Service had liabilities of CN¥55.3b due within 12 months, and liabilities of CN¥2.83b due beyond 12 months. Offsetting this, it had CN¥1.69b in cash and CN¥29.6b in receivables that were due within 12 months. So it has liabilities totalling CN¥26.8b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CN¥31.4b. 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). 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).
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. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Sinopec Oilfield Service saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Sinopec Oilfield Service has 2 warning signs (and 1 which can't be ignored) we think you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
When trading Sinopec Oilfield Service or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.