Warren Buffett said: “Volatility is far from synonymous with risk. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Yanchang Petroleum International Limited (HKG:346) uses debt in its business. But does this debt worry shareholders?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Yanchang Petroleum International
What is Yanchang Petroleum International’s debt?
The graph below, which you can click on for more details, shows that Yanchang Petroleum International had a debt of HK$870.3 million in December 2021; about the same as the previous year. On the other hand, he has HK$394.1 million in cash, resulting in a net debt of around HK$476.2 million.
How healthy is Yanchang Petroleum International’s balance sheet?
The latest balance sheet data shows that Yanchang Petroleum International had liabilities of HK$2.91 billion due within the year, and liabilities of HK$434.6 million falling due thereafter. As compensation for these obligations, it had cash of HK$394.1 million and receivables valued at HK$664.9 million due within 12 months. It therefore has liabilities totaling HK$2.28 billion more than its cash and short-term receivables, combined.
That deficit casts a shadow over the HK$1.05 billion business, like a colossus towering over mere mortals. We would therefore be watching his balance sheet closely, no doubt. After all, Yanchang Petroleum International would likely need a major recapitalization if it were to pay its creditors today.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Yanchang Petroleum International’s debt to EBITDA ratio (2.6) suggests it uses some debt, its interest coverage is very low at 2.1, suggesting high leverage. It appears that the company is incurring significant depreciation and amortization costs, so perhaps its debt load is heavier than it appears at first glance, since EBITDA is undoubtedly a generous measure benefits. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company lately. A redeeming factor for Yanchang Petroleum International is that it has turned last year’s EBIT loss into a HK$82 million gain, over the past twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But it is the profits of Yanchang Petroleum International that will influence the balance sheet in the future. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cold hard cash, not with book profits. It is therefore important to check how much of its earnings before interest and taxes (EBIT) converts into actual free cash flow. Over the past year, Yanchang Petroleum International has experienced substantial negative free cash flow, overall. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
To be frank, Yanchang Petroleum International’s EBIT to free cash flow conversion and track record of keeping its total liabilities under control makes us rather uncomfortable with its level of leverage. That said, its ability to grow its EBIT is not such a concern. After reviewing the data points discussed, we believe that Yanchang Petroleum International has too much debt. That kind of risk is acceptable to some, but it certainly doesn’t float our boat. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To do this, you need to find out about the 3 warning signs we spotted some with Yanchang Petroleum International (including 1 which is a bit unpleasant).
If you are interested in investing in businesses that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.