Is Shandong Molong Petroleum Machinery (HKG:568) Using Debt In A Risky Way?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Shandong Molong Petroleum Machinery Company Limited (HKG:568) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Shandong Molong Petroleum Machinery

How Much Debt Does Shandong Molong Petroleum Machinery Carry?

You can click the graphic below for the historical numbers, but it shows that Shandong Molong Petroleum Machinery had CN¥1.76b of debt in September 2023, down from CN¥2.23b, one year before. However, it also had CN¥174.5m in cash, and so its net debt is CN¥1.59b.

A Look At Shandong Molong Petroleum Machinery's Liabilities

The latest balance sheet data shows that Shandong Molong Petroleum Machinery had liabilities of CN¥2.54b due within a year, and liabilities of CN¥113.1m falling due after that. Offsetting these obligations, it had cash of CN¥174.5m as well as receivables valued at CN¥360.6m due within 12 months. So its liabilities total CN¥2.11b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥2.53b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Molong Petroleum Machinery's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Shandong Molong Petroleum Machinery made a loss at the EBIT level, and saw its revenue drop to CN¥1.5b, which is a fall of 49%. That makes us nervous, to say the least.

Caveat Emptor

While Shandong Molong Petroleum Machinery's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable CN¥258m 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. However, it doesn't help that it burned through CN¥21m of cash over the last year. 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 instance, we've identified 1 warning sign for Shandong Molong Petroleum Machinery that you should be aware of.

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.

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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.