The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We note that China Petroleum Engineering Corporation (SHSE:600339) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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, 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 China Petroleum Engineering's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 China Petroleum Engineering had debt of CN¥2.26b, up from none in one year. However, its balance sheet shows it holds CN¥34.1b in cash, so it actually has CN¥31.9b net cash.

A Look At China Petroleum Engineering's Liabilities

We can see from the most recent balance sheet that China Petroleum Engineering had liabilities of CN¥77.3b falling due within a year, and liabilities of CN¥4.09b due beyond that. On the other hand, it had cash of CN¥34.1b and CN¥45.2b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.07b.

Given China Petroleum Engineering has a market capitalization of CN¥19.4b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, China Petroleum Engineering also has more cash than debt, so we're pretty confident it can manage its debt safely.

The good news is that China Petroleum Engineering has increased its EBIT by 9.2% 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 ultimately the future profitability of the business will decide if China Petroleum Engineering 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 company can only pay off debt with cold hard cash, not accounting profits. China Petroleum Engineering may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, China Petroleum Engineering actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While China Petroleum Engineering does have more liabilities than liquid assets, it also has net cash of CN¥31.9b. And it impressed us with free cash flow of CN¥2.7b, being 134% of its EBIT. So is China Petroleum Engineering's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for China Petroleum Engineering 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.