Is China Petroleum & Chemical (HKG:386) 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. As with many other companies China Petroleum & Chemical Corporation (HKG:386) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Net Debt?

As you can see below, China Petroleum & Chemical had CN¥177.9b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥191.4b in cash, so it actually has CN¥13.5b net cash.

A Look At China Petroleum & Chemical's Liabilities

According to the last reported balance sheet, China Petroleum & Chemical had liabilities of CN¥601.6b due within 12 months, and liabilities of CN¥329.2b due beyond 12 months. Offsetting these obligations, it had cash of CN¥191.4b as well as receivables valued at CN¥43.9b due within 12 months. So it has liabilities totalling CN¥695.5b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's huge CN¥466.7b 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. China Petroleum & Chemical boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

It is just as well that China Petroleum & Chemical's load is not too heavy, because its EBIT was down 66% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. During the last three years, China Petroleum & Chemical produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While China Petroleum & Chemical does have more liabilities than liquid assets, it also has net cash of CN¥13.5b. The cherry on top was that in converted 70% of that EBIT to free cash flow, bringing in CN¥7.5b. Despite the cash, we do find China Petroleum & Chemical's EBIT growth rate concerning, so we're not particularly comfortable with the stock. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with China Petroleum & Chemical , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

When trading China Petroleum & Chemical or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.