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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that PetroChina Company Limited (HKG:857) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for PetroChina

What Is PetroChina's Net Debt?

You can click the graphic below for the historical numbers, but it shows that PetroChina had CN¥377.4b of debt in September 2021, down from CN¥462.3b, one year before. However, because it has a cash reserve of CN¥205.0b, its net debt is less, at about CN¥172.4b.

How Healthy Is PetroChina's Balance Sheet?

We can see from the most recent balance sheet that PetroChina had liabilities of CN¥609.4b falling due within a year, and liabilities of CN¥549.7b due beyond that. On the other hand, it had cash of CN¥205.0b and CN¥91.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥862.6b.

Given this deficit is actually higher than the company's massive market capitalization of CN¥826.5b, 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.

While PetroChina's low debt to EBITDA ratio of 0.59 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. PetroChina grew its EBIT by 7.2% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if PetroChina can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, PetroChina's free cash flow amounted to 42% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

PetroChina's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its net debt to EBITDA tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that PetroChina is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for PetroChina you should be aware of, and 1 of them is a bit unpleasant.

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.

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.

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