We Think Sinopec Shanghai Petrochemical (HKG:338) Can Stay On Top Of Its 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.' 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. Importantly, Sinopec Shanghai Petrochemical Company Limited (HKG:338) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sinopec Shanghai Petrochemical

How Much Debt Does Sinopec Shanghai Petrochemical Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Sinopec Shanghai Petrochemical had CN¥3.77b of debt, an increase on CN¥1.60b, over one year. However, its balance sheet shows it holds CN¥12.4b in cash, so it actually has CN¥8.62b net cash.

How Strong Is Sinopec Shanghai Petrochemical's Balance Sheet?

According to the last reported balance sheet, Sinopec Shanghai Petrochemical had liabilities of CN¥22.0b due within 12 months, and liabilities of CN¥856.5m due beyond 12 months. On the other hand, it had cash of CN¥12.4b and CN¥3.20b worth of receivables due within a year. So it has liabilities totalling CN¥7.31b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Sinopec Shanghai Petrochemical is worth CN¥28.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. 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.

In fact Sinopec Shanghai Petrochemical's saving grace is its low debt levels, because its EBIT has tanked 53% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Sinopec Shanghai Petrochemical 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 last two years, Sinopec Shanghai Petrochemical recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While Sinopec Shanghai Petrochemical does have more liabilities than liquid assets, it also has net cash of CN¥8.62b. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in -CN¥659m. So we don't have any problem with Sinopec Shanghai Petrochemical's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Sinopec Shanghai Petrochemical (of which 1 is a bit unpleasant!) you should know about.

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.