Is Magnificent Hotel Investments (HKG:201) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Magnificent Hotel Investments Limited (HKG:201) does carry debt. But should shareholders be worried about its use of debt?

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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Magnificent Hotel Investments

What Is Magnificent Hotel Investments's Debt?

The chart below, which you can click on for greater detail, shows that Magnificent Hotel Investments had HK$499.4m in debt in December 2021; about the same as the year before. However, because it has a cash reserve of HK$260.3m, its net debt is less, at about HK$239.1m.

A Look At Magnificent Hotel Investments' Liabilities

The latest balance sheet data shows that Magnificent Hotel Investments had liabilities of HK$572.4m due within a year, and liabilities of HK$91.4m falling due after that. Offsetting this, it had HK$260.3m in cash and HK$6.34m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$397.1m.

While this might seem like a lot, it is not so bad since Magnificent Hotel Investments has a market capitalization of HK$1.06b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Magnificent Hotel Investments has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 2.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, the silver lining was that Magnificent Hotel Investments achieved a positive EBIT of HK$15m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Magnificent Hotel Investments'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Magnificent Hotel Investments actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On our analysis Magnificent Hotel Investments's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. Looking at all this data makes us feel a little cautious about Magnificent Hotel Investments's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Magnificent Hotel Investments (of which 1 is significant!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.