These 4 Measures Indicate That PetroChina (HKG:857) Is Using Debt Extensively

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.' 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 PetroChina Company Limited (HKG:857) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for PetroChina

What Is PetroChina's Debt?

As you can see below, PetroChina had CN¥367.9b of debt at December 2020, down from CN¥446.7b a year prior. On the flip side, it has CN¥146.0b in cash leading to net debt of about CN¥222.0b.

A Look At PetroChina's Liabilities

The latest balance sheet data shows that PetroChina had liabilities of CN¥605.4b due within a year, and liabilities of CN¥516.1b falling due after that. Offsetting these obligations, it had cash of CN¥146.0b as well as receivables valued at CN¥87.2b due within 12 months. So it has liabilities totalling CN¥888.3b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's massive market capitalization of CN¥744.9b, we think shareholders really should watch PetroChina's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

PetroChina has a low debt to EBITDA ratio of only 0.91. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. The modesty of its debt load may become crucial for PetroChina if management cannot prevent a repeat of the 72% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 PetroChina'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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, PetroChina produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say PetroChina's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that PetroChina's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Be aware that PetroChina is showing 2 warning signs in our investment analysis , you should know about...

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. 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.
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