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. 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. Importantly, Associated International Hotels Limited (HKG:105) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Associated International Hotels's Debt?
As you can see below, Associated International Hotels had HK$200.0m of debt, at September 2019, which is about the same as the year before. You can click the chart for greater detail. But it also has HK$726.2m in cash to offset that, meaning it has HK$526.2m net cash.
A Look At Associated International Hotels's Liabilities
According to the last reported balance sheet, Associated International Hotels had liabilities of HK$449.0m due within 12 months, and liabilities of HK$284.1m due beyond 12 months. Offsetting these obligations, it had cash of HK$726.2m as well as receivables valued at HK$20.3m due within 12 months. So these liquid assets roughly match the total liabilities.
Having regard to Associated International Hotels's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the HK$6.48b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Associated International Hotels has more cash than debt is arguably a good indication that it can manage its debt safely.
On the other hand, Associated International Hotels saw its EBIT drop by 3.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Associated International Hotels 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Associated International Hotels 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, Associated International Hotels recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Associated International Hotels has net cash of HK$526.2m, as well as more liquid assets than liabilities. The cherry on top was that in converted 84% of that EBIT to free cash flow, bringing in HK$384m. So is Associated International Hotels's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Associated International Hotels is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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