Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that SINOPEC Engineering (Group) Co., Ltd. (HKG:2386) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for SINOPEC Engineering (Group)

How Much Debt Does SINOPEC Engineering (Group) Carry?

You can click the graphic below for the historical numbers, but it shows that SINOPEC Engineering (Group) had CN¥134.2m of debt in June 2022, down from CN¥174.6m, one year before. But it also has CN¥17.4b in cash to offset that, meaning it has CN¥17.3b net cash.

How Healthy Is SINOPEC Engineering (Group)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that SINOPEC Engineering (Group) had liabilities of CN¥40.4b due within 12 months and liabilities of CN¥2.35b due beyond that. Offsetting these obligations, it had cash of CN¥17.4b as well as receivables valued at CN¥40.3b due within 12 months. So it can boast CN¥15.0b 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 31% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if SINOPEC Engineering (Group) can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, SINOPEC Engineering (Group) actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While we empathize with investors who find debt concerning, the bottom line is that SINOPEC Engineering (Group) has net cash of CN¥17.3b and plenty of liquid assets. And it impressed us with free cash flow of CN¥2.7b, being 139% of its EBIT. So we don't think SINOPEC Engineering (Group)'s use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for SINOPEC Engineering (Group) that you should be aware of.

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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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.