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. We note that Zhongman Petroleum and Natural Gas Group Corp.,Ltd. (SHSE:603619) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhongman Petroleum and Natural Gas GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Zhongman Petroleum and Natural Gas GroupLtd had debt of CN¥3.38b, up from CN¥1.82b in one year. However, because it has a cash reserve of CN¥1.17b, its net debt is less, at about CN¥2.21b.

How Strong Is Zhongman Petroleum and Natural Gas GroupLtd's Balance Sheet?

According to the last reported balance sheet, Zhongman Petroleum and Natural Gas GroupLtd had liabilities of CN¥4.26b due within 12 months, and liabilities of CN¥2.15b due beyond 12 months. Offsetting this, it had CN¥1.17b in cash and CN¥1.03b in receivables that were due within 12 months. So its liabilities total CN¥4.20b more than the combination of its cash and short-term receivables.

Zhongman Petroleum and Natural Gas GroupLtd has a market capitalization of CN¥9.36b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 1.5, Zhongman Petroleum and Natural Gas GroupLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.8 times interest expense) certainly does not do anything to dispel this impression. The good news is that Zhongman Petroleum and Natural Gas GroupLtd has increased its EBIT by 8.5% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhongman Petroleum and Natural Gas GroupLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Considering the last three years, Zhongman Petroleum and Natural Gas GroupLtd actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Zhongman Petroleum and Natural Gas GroupLtd's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Zhongman Petroleum and Natural Gas GroupLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zhongman Petroleum and Natural Gas GroupLtd is showing 2 warning signs in our investment analysis , you should know about...

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.

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