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.' 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. Importantly, CNPC Capital Company Limited (SZSE:000617) does carry debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for CNPC Capital

How Much Debt Does CNPC Capital Carry?

The chart below, which you can click on for greater detail, shows that CNPC Capital had CN¥146.8b in debt in September 2022; about the same as the year before. However, because it has a cash reserve of CN¥92.4b, its net debt is less, at about CN¥54.4b.

How Strong Is CNPC Capital's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CNPC Capital had liabilities of CN¥795.8b due within 12 months and liabilities of CN¥18.1b due beyond that. Offsetting this, it had CN¥92.4b in cash and CN¥329.9b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥391.6b.

The deficiency here weighs heavily on the CN¥73.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, CNPC Capital would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While CNPC Capital has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 2.4. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. Importantly CNPC Capital's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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 CNPC Capital 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, CNPC Capital 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.

Our View

We'd go so far as to say CNPC Capital's level of total liabilities was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making CNPC Capital stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that CNPC Capital is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.