Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies SINOPEC Engineering (Group) Co., Ltd. (HKG:2386) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for SINOPEC Engineering (Group)

What Is SINOPEC Engineering (Group)'s Debt?

As you can see below, SINOPEC Engineering (Group) had CN¥63.8m of debt at December 2021, down from CN¥163.1m a year prior. However, its balance sheet shows it holds CN¥18.7b in cash, so it actually has CN¥18.6b net cash.

A Look At SINOPEC Engineering (Group)'s Liabilities

We can see from the most recent balance sheet that SINOPEC Engineering (Group) had liabilities of CN¥41.4b falling due within a year, and liabilities of CN¥2.42b due beyond that. On the other hand, it had cash of CN¥18.7b and CN¥38.7b worth of receivables due within a year. So it can boast CN¥13.6b more liquid assets than total liabilities.

This surplus strongly suggests that SINOPEC Engineering (Group) has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, SINOPEC Engineering (Group) boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact SINOPEC Engineering (Group)'s saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SINOPEC Engineering (Group) can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While SINOPEC Engineering (Group) has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, SINOPEC Engineering (Group) generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case SINOPEC Engineering (Group) has CN¥18.6b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥2.3b, being 82% 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. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for SINOPEC Engineering (Group) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.