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

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. We can see that Yanchang Petroleum International Limited (HKG:346) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Yanchang Petroleum International

What Is Yanchang Petroleum International's Debt?

The chart below, which you can click on for greater detail, shows that Yanchang Petroleum International had HK$870.3m in debt in December 2021; about the same as the year before. On the flip side, it has HK$394.1m in cash leading to net debt of about HK$476.2m.

How Healthy Is Yanchang Petroleum International's Balance Sheet?

The latest balance sheet data shows that Yanchang Petroleum International had liabilities of HK$2.91b due within a year, and liabilities of HK$434.6m falling due after that. Offsetting these obligations, it had cash of HK$394.1m as well as receivables valued at HK$664.9m due within 12 months. So it has liabilities totalling HK$2.28b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$1.05b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Yanchang Petroleum International would likely require a major re-capitalisation if it had to pay its creditors today.

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 Yanchang Petroleum International's debt to EBITDA ratio (2.6) 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. One redeeming factor for Yanchang Petroleum International is that it turned last year's EBIT loss into a gain of HK$82m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 that may be a result of expenditure for growth, it does make the debt far 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. Having said that, its ability to grow its EBIT isn't such a worry. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Yanchang Petroleum International (including 1 which is a bit unpleasant) .

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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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.