Sinopec Shanghai Petrochemical (HKG:338) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Sinopec Shanghai Petrochemical Company Limited (HKG:338) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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

See our latest analysis for Sinopec Shanghai Petrochemical

What Is Sinopec Shanghai Petrochemical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Sinopec Shanghai Petrochemical had CN¥4.56b of debt, an increase on CN¥3.03b, over one year. However, its balance sheet shows it holds CN¥7.15b in cash, so it actually has CN¥2.59b net cash.

A Look At Sinopec Shanghai Petrochemical's Liabilities

According to the last reported balance sheet, Sinopec Shanghai Petrochemical had liabilities of CN¥17.0b due within 12 months, and liabilities of CN¥175.4m due beyond 12 months. Offsetting these obligations, it had cash of CN¥7.15b as well as receivables valued at CN¥3.83b due within 12 months. So it has liabilities totalling CN¥6.25b more than its cash and near-term receivables, combined.

Of course, Sinopec Shanghai Petrochemical has a market capitalization of CN¥37.2b, 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. 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.

It was also good to see that despite losing money on the EBIT line last year, Sinopec Shanghai Petrochemical turned things around in the last 12 months, delivering and EBIT of CN¥2.8b. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sinopec Shanghai Petrochemical 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Sinopec Shanghai Petrochemical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Sinopec Shanghai Petrochemical recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing up

While Sinopec Shanghai Petrochemical does have more liabilities than liquid assets, it also has net cash of CN¥2.59b. So we don't have any problem with Sinopec Shanghai Petrochemical's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Sinopec Shanghai Petrochemical has 1 warning sign we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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