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.' 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. As with many other companies Shandong Molong Petroleum Machinery Company Limited (HKG:568) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Shandong Molong Petroleum Machinery's Debt?
The image below, which you can click on for greater detail, shows that Shandong Molong Petroleum Machinery had debt of CN¥1.63b at the end of December 2023, a reduction from CN¥2.00b over a year. However, it does have CN¥102.4m in cash offsetting this, leading to net debt of about CN¥1.53b.
How Strong Is Shandong Molong Petroleum Machinery's Balance Sheet?
According to the last reported balance sheet, Shandong Molong Petroleum Machinery had liabilities of CN¥2.42b due within 12 months, and liabilities of CN¥130.3m due beyond 12 months. On the other hand, it had cash of CN¥102.4m and CN¥334.8m worth of receivables due within a year. So it has liabilities totalling CN¥2.12b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's CN¥1.92b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shandong Molong Petroleum Machinery's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Over 12 months, Shandong Molong Petroleum Machinery made a loss at the EBIT level, and saw its revenue drop to CN¥1.3b, which is a fall of 52%. That makes us nervous, to say the least.
Caveat Emptor
While Shandong Molong Petroleum Machinery's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Its EBIT loss was a whopping CN¥208m. When we look at that alongside the significant liabilities, we're not particularly confident about the company. It would need to improve its operations quickly for us to be interested in it. For example, we would not want to see a repeat of last year's loss of CN¥567m. And until that time we think this is a risky stock. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Shandong Molong Petroleum Machinery (including 1 which is a bit concerning) .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.