Is Yanchang Petroleum International (HKG:346) Using Too Much Debt?

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Yanchang Petroleum International Limited (HKG:346) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Yanchang Petroleum International

What Is Yanchang Petroleum International's Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Yanchang Petroleum International had debt of HK$884.9m, up from HK$708.5m in one year. On the flip side, it has HK$251.1m in cash leading to net debt of about HK$633.8m.

How Healthy Is Yanchang Petroleum International's Balance Sheet?

The latest balance sheet data shows that Yanchang Petroleum International had liabilities of HK$3.31b due within a year, and liabilities of HK$514.2m falling due after that. Offsetting this, it had HK$251.1m in cash and HK$1.08b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$2.50b.

This deficit casts a shadow over the HK$1.05b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Yanchang Petroleum International would likely require a major re-capitalisation if it had to pay its creditors today.

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

Weak interest cover of 0.59 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Yanchang Petroleum International like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that Yanchang Petroleum International achieved a positive EBIT of HK$29m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Yanchang Petroleum International's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Yanchang Petroleum International saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Yanchang Petroleum International's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Yanchang Petroleum International has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Case in point: We've spotted 1 warning sign for Yanchang Petroleum International 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.