We Think China Oil And Gas Group (HKG:603) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 China Oil And Gas Group Limited (HKG:603) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for China Oil And Gas Group

What Is China Oil And Gas Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 China Oil And Gas Group had HK$10.6b of debt, an increase on HK$7.19b, over one year. However, it also had HK$6.50b in cash, and so its net debt is HK$4.15b.

How Healthy Is China Oil And Gas Group's Balance Sheet?

We can see from the most recent balance sheet that China Oil And Gas Group had liabilities of HK$7.57b falling due within a year, and liabilities of HK$7.20b due beyond that. Offsetting these obligations, it had cash of HK$6.50b as well as receivables valued at HK$2.46b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$5.81b.

This deficit casts a shadow over the HK$2.51b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Oil And Gas Group would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

China Oil And Gas Group's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 71.0 times, makes us even more comfortable. Sadly, China Oil And Gas Group's EBIT actually dropped 5.8% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Oil And Gas Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, China Oil And Gas Group recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say China Oil And Gas Group's level of total liabilities was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that China Oil And Gas Group is in the Gas Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Oil And Gas Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For example, we've discovered 2 warning signs for China Oil And Gas Group (1 shouldn't be ignored!) that you should be aware of before investing here.

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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