Is CNOOC (HKG:883) A Risky Investment?

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.' 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. We note that CNOOC Limited (HKG:883) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 CNOOC

How Much Debt Does CNOOC Carry?

You can click the graphic below for the historical numbers, but it shows that CNOOC had CN¥110.1b of debt in December 2023, down from CN¥126.0b, one year before. However, its balance sheet shows it holds CN¥194.9b in cash, so it actually has CN¥84.8b net cash.

How Healthy Is CNOOC's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CNOOC had liabilities of CN¥123.9b due within 12 months and liabilities of CN¥213.8b due beyond that. Offsetting these obligations, it had cash of CN¥194.9b as well as receivables valued at CN¥38.1b due within 12 months. So its liabilities total CN¥104.8b more than the combination of its cash and short-term receivables.

Of course, CNOOC has a titanic market capitalization of CN¥884.4b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, CNOOC boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, CNOOC's EBIT dived 13%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if CNOOC 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. CNOOC 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. Over the most recent three years, CNOOC recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

Although CNOOC's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥84.8b. So we are not troubled with CNOOC's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for CNOOC (1 is concerning!) that you should be aware of before investing here.

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.