David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that China Oil And Gas Group Limited (HKG:603) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
You can click the graphic below for the historical numbers, but it shows that as of December 2018 China Oil And Gas Group had HK$6.55b of debt, an increase on HK$5.72b, over one year. However, it also had HK$2.67b in cash, and so its net debt is HK$3.88b.
SEHK:603 Historical Debt, July 29th 2019
A Look At China Oil And Gas Group's Liabilities
Zooming in on the latest balance sheet data, we can see that China Oil And Gas Group had liabilities of HK$4.61b due within 12 months and liabilities of HK$5.50b due beyond that. Offsetting this, it had HK$2.67b in cash and HK$1.76b in receivables that were due within 12 months. So it has liabilities totalling HK$5.69b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$1.85b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, China Oil And Gas Group would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
China Oil And Gas Group's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 16.6 is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. We saw China Oil And Gas Group grow its EBIT by 9.2% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since China Oil And Gas Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, China Oil And Gas Group recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Mulling over China Oil And Gas Group's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. 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. Once we consider all the factors above, together, it seems to us that China Oil And Gas Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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