Is Sinopec Shanghai Petrochemical (HKG:338) Using Too Much Debt?

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.' 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 Sinopec Shanghai Petrochemical Company Limited (HKG:338) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sinopec Shanghai Petrochemical

What Is Sinopec Shanghai Petrochemical's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Sinopec Shanghai Petrochemical had debt of CN¥3.04b, up from CN¥1.04b in one year. However, it does have CN¥5.90b in cash offsetting this, leading to net cash of CN¥2.86b.

How Healthy Is Sinopec Shanghai Petrochemical's Balance Sheet?

We can see from the most recent balance sheet that Sinopec Shanghai Petrochemical had liabilities of CN¥16.7b falling due within a year, and liabilities of CN¥166.1m due beyond that. Offsetting this, it had CN¥5.90b in cash and CN¥3.47b in receivables that were due within 12 months. So its liabilities total CN¥7.47b more than the combination of its cash and short-term receivables.

Sinopec Shanghai Petrochemical has a market capitalization of CN¥30.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Sinopec Shanghai Petrochemical boasts net cash, so it's fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. 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.

In the last year Sinopec Shanghai Petrochemical had a loss before interest and tax, and actually shrunk its revenue by 22%, to CN¥80b. To be frank that doesn't bode well.

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 generated positive free cash flow of CN¥1.9b. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. Until we see some positive EBIT, we're a bit cautious of the stock, not least because of the rather modest revenue growth. 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. For example, we've discovered 1 warning sign for Sinopec Shanghai Petrochemical 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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