China Oilfield Services (HKG:2883) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 note that China Oilfield Services Limited (HKG:2883) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

See our latest analysis for China Oilfield Services

How Much Debt Does China Oilfield Services Carry?

The chart below, which you can click on for greater detail, shows that China Oilfield Services had CN¥25.3b in debt in September 2021; about the same as the year before. However, it also had CN¥7.51b in cash, and so its net debt is CN¥17.8b.

How Healthy Is China Oilfield Services' Balance Sheet?

We can see from the most recent balance sheet that China Oilfield Services had liabilities of CN¥18.3b falling due within a year, and liabilities of CN¥18.9b due beyond that. Offsetting these obligations, it had cash of CN¥7.51b as well as receivables valued at CN¥14.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.9b.

China Oilfield Services has a market capitalization of CN¥53.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Oilfield Services has net debt to EBITDA of 3.0 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.8 suggests it can easily service that debt. Importantly, China Oilfield Services's EBIT fell a jaw-dropping 48% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 China Oilfield Services 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Oilfield Services generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

China Oilfield Services's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Looking at all this data makes us feel a little cautious about China Oilfield Services's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Oilfield Services you should know about.

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.