Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that PetroChina Company Limited (HKG:857) has a debt on its balance sheet. But the more important question is: what risk does this debt create?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for PetroChina
What is PetroChina’s debt?
As you can see below, PetroChina had a debt of 342.5 billion yen in March 2022, compared to 416.2 billion yen the previous year. However, since it has a cash reserve of 194.8 billion Canadian yen, its net debt is less, at around 147.6 billion Canadian yen.
How strong is PetroChina’s balance sheet?
According to the latest published balance sheet, PetroChina had liabilities of 603.6 billion Canadian yen due within 12 months and liabilities of 554.9 billion Canadian yen due beyond 12 months. On the other hand, it had a cash position of 194.8 billion Canadian yen and 95.1 billion national yen of receivables due within the year. Thus, its liabilities total 868.6 billion Canadian yen more than the combination of its cash and short-term receivables.
This is a mountain of leverage, even compared to its gargantuan market capitalization of ¥1.03t CN. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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). Thus, we consider debt to earnings with and without amortization and depreciation expense.
PetroChina has a low net debt to EBITDA ratio of just 0.37. And its EBIT easily covers its interest charges, being 10.8 times higher. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. What is even more impressive is that PetroChina increased its EBIT by 115% year-over-year. If sustained, this growth will make debt even more manageable in years to come. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether PetroChina can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, PetroChina has had free cash flow of 59% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
PetroChina’s EBIT growth rate suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But truth be told, we think his total passive level undermines that impression a bit. Looking at all of the aforementioned factors together, it seems to us that PetroChina can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 2 warning signs for PetroChina you should be aware, and one of them is a bit of a concern.
If you are interested in investing in companies 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.