These 4 Measures Indicate That Sinopec Oilfield Service (HKG:1033) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Sinopec Oilfield Service Corporation (HKG:1033) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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

How Much Debt Does Sinopec Oilfield Service Carry?

You can click the graphic below for the historical numbers, but it shows that Sinopec Oilfield Service had CN¥20.7b of debt in March 2021, down from CN¥23.4b, one year before. However, because it has a cash reserve of CN¥1.61b, its net debt is less, at about CN¥19.1b.

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¥52.7b due within 12 months and liabilities of CN¥1.94b due beyond that. Offsetting this, it had CN¥1.61b in cash and CN¥25.9b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥27.1b.

This deficit is considerable relative to its market capitalization of CN¥30.0b, 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 we wouldn't worry about Sinopec Oilfield Service's net debt to EBITDA ratio of 4.4, we think its super-low interest cover of 2.0 times is a sign of 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. The good news is that Sinopec Oilfield Service improved its EBIT by 8.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. 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 last three 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.

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. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Sinopec Oilfield Service to be really rather risky, as a result of its balance sheet health. 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. However, not all investment risk resides within the balance sheet - far from it. Be aware that Sinopec Oilfield Service is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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