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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that China Petroleum & Chemical Corporation (HKG:386) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for China Petroleum & Chemical
How Much Debt Does China Petroleum & Chemical Carry?
The chart below, which you can click on for greater detail, shows that China Petroleum & Chemical had CN¥192.2b in debt in June 2019; about the same as the year before. On the flip side, it has CN¥182.7b in cash leading to net debt of about CN¥9.51b.
How Healthy Is China Petroleum & Chemical's Balance Sheet?
We can see from the most recent balance sheet that China Petroleum & Chemical had liabilities of CN¥605.4b falling due within a year, and liabilities of CN¥352.2b due beyond that. Offsetting these obligations, it had cash of CN¥182.7b as well as receivables valued at CN¥79.4b due within 12 months. So it has liabilities totalling CN¥695.5b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of CN¥584.5b, we think shareholders really should watch China Petroleum & Chemical's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.