Is Shandong Molong Petroleum Machinery (HKG:568) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Shandong Molong Petroleum Machinery Company Limited (HKG:568) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shandong Molong Petroleum Machinery

What Is Shandong Molong Petroleum Machinery's Debt?

The image below, which you can click on for greater detail, shows that Shandong Molong Petroleum Machinery had debt of CN¥2.06b at the end of June 2023, a reduction from CN¥2.38b over a year. On the flip side, it has CN¥463.0m in cash leading to net debt of about CN¥1.59b.

How Strong Is Shandong Molong Petroleum Machinery's Balance Sheet?

We can see from the most recent balance sheet that Shandong Molong Petroleum Machinery had liabilities of CN¥2.84b falling due within a year, and liabilities of CN¥130.9m due beyond that. On the other hand, it had cash of CN¥463.0m and CN¥444.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.07b.

This deficit is considerable relative to its market capitalization of CN¥3.19b, so it does suggest shareholders should keep an eye on Shandong Molong Petroleum Machinery's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shandong Molong Petroleum Machinery will need earnings to service that debt. 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.

Over 12 months, Shandong Molong Petroleum Machinery made a loss at the EBIT level, and saw its revenue drop to CN¥2.0b, which is a fall of 42%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Shandong Molong Petroleum Machinery's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost CN¥252m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled CN¥98m in negative free cash flow over the last twelve months. So to be blunt we think it is risky. 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. For example - Shandong Molong Petroleum Machinery has 1 warning sign we think you should be aware of.

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.