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.' 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. As with many other companies Sinopec Shanghai Petrochemical Company Limited (HKG:338) makes use of debt. 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 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Sinopec Shanghai Petrochemical Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Sinopec Shanghai Petrochemical had CN¥4.57b of debt, an increase on CN¥1.55b, over one year. But it also has CN¥11.0b in cash to offset that, meaning it has CN¥6.40b net cash.
How Strong Is Sinopec Shanghai Petrochemical's Balance Sheet?
We can see from the most recent balance sheet that Sinopec Shanghai Petrochemical had liabilities of CN¥15.2b falling due within a year, and liabilities of CN¥161.9m due beyond that. On the other hand, it had cash of CN¥11.0b and CN¥2.40b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.02b.
Given Sinopec Shanghai Petrochemical has a market capitalization of CN¥32.5b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Sinopec Shanghai Petrochemical also has more cash than debt, so we're pretty confident it can manage its debt safely. 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 Sinopec Shanghai Petrochemical'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.
Over 12 months, Sinopec Shanghai Petrochemical made a loss at the EBIT level, and saw its revenue drop to CN¥75b, which is a fall of 25%. That makes us nervous, to say the least.
So How Risky Is Sinopec Shanghai Petrochemical?
Although Sinopec Shanghai Petrochemical had an earnings before interest and tax (EBIT) loss over the last twelve months, it made a statutory profit of CN¥628m. So when you consider it has net cash, along with the statutory profit, the stock probably isn't as risky as it might seem, at least in the short term. Until we see some positive EBIT, we're a bit cautious of the stock, not least because of the rather modest revenue growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Sinopec Shanghai Petrochemical 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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