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. Importantly, SINOPEC Engineering (Group) Co., Ltd. (HKG:2386) does carry debt. But is this debt a concern to shareholders?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is SINOPEC Engineering (Group)'s Net Debt?
As you can see below, SINOPEC Engineering (Group) had CN¥385.0m of debt at June 2019, down from CN¥569.0m a year prior. However, it does have CN¥13.3b in cash offsetting this, leading to net cash of CN¥12.9b.
How Strong Is SINOPEC Engineering (Group)'s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that SINOPEC Engineering (Group) had liabilities of CN¥40.8b due within 12 months and liabilities of CN¥2.98b due beyond that. Offsetting these obligations, it had cash of CN¥13.3b as well as receivables valued at CN¥43.5b due within 12 months. So it actually has CN¥13.0b more liquid assets than total liabilities.
This excess liquidity is a great indication that SINOPEC Engineering (Group)'s balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, SINOPEC Engineering (Group) boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, SINOPEC Engineering (Group)'s EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Engineering (Group)'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. SINOPEC Engineering (Group) 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. Happily for any shareholders, SINOPEC Engineering (Group) actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While it is always sensible to investigate a company's debt, in this case SINOPEC Engineering (Group) has CN¥12.9b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥1.9b, being 248% of its EBIT. So we don't think SINOPEC Engineering (Group)'s use of debt is risky. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with SINOPEC Engineering (Group) , and understanding them should be part of your investment process.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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