Is China Petroleum & Chemical (HKG:386) A Risky Investment?

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.' 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 can see that China Petroleum & Chemical Corporation (HKG:386) does use debt in its business. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for China Petroleum & Chemical

What Is China Petroleum & Chemical's Debt?

The image below, which you can click on for greater detail, shows that China Petroleum & Chemical had debt of CN¥158.1b at the end of September 2021, a reduction from CN¥177.9b over a year. But it also has CN¥207.4b in cash to offset that, meaning it has CN¥49.4b net cash.

A Look At China Petroleum & Chemical's Liabilities

Zooming in on the latest balance sheet data, we can see that China Petroleum & Chemical had liabilities of CN¥637.8b due within 12 months and liabilities of CN¥339.4b due beyond that. Offsetting these obligations, it had cash of CN¥207.4b as well as receivables valued at CN¥83.8b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥686.0b.

When you consider that this deficiency exceeds the company's huge CN¥481.4b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Given that China Petroleum & Chemical has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

Better yet, China Petroleum & Chemical grew its EBIT by 405% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Petroleum & Chemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. China Petroleum & Chemical may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, China Petroleum & Chemical recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

Although China Petroleum & Chemical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥49.4b. And we liked the look of last year's 405% year-on-year EBIT growth. So while China Petroleum & Chemical does not have a great balance sheet, it's certainly not too bad. 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. For example China Petroleum & Chemical has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.