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, Zhejiang New Century Hotel Management Co., Ltd. (HKG:1158) does carry 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Zhejiang New Century Hotel Management Carry?
As you can see below, at the end of December 2018, Zhejiang New Century Hotel Management had CN¥190.5m of debt, up from CN¥165.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥367.7m in cash, so it actually has CN¥177.2m net cash.
How Healthy Is Zhejiang New Century Hotel Management's Balance Sheet?
The latest balance sheet data shows that Zhejiang New Century Hotel Management had liabilities of CN¥667.4m due within a year, and liabilities of CN¥205.5m falling due after that. Offsetting this, it had CN¥367.7m in cash and CN¥147.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥357.6m.
Given Zhejiang New Century Hotel Management has a market capitalization of CN¥3.72b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Zhejiang New Century Hotel Management also has more cash than debt, so we're pretty confident it can manage its debt safely.
Also good is that Zhejiang New Century Hotel Management grew its EBIT at 11% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhejiang New Century Hotel Management can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Zhejiang New Century Hotel Management 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. In the last three years, Zhejiang New Century Hotel Management's free cash flow amounted to 29% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We could understand if investors are concerned about Zhejiang New Century Hotel Management's liabilities, but we can be reassured by the fact it has has net cash of CN¥177m. On top of that, it increased its EBIT by 11% in the last twelve months. So we don't have any problem with Zhejiang New Century Hotel Management's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Zhejiang New Century Hotel Management insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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