Far East Hotels and Entertainment (HKG:37) Seems To Use Debt Quite Sensibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Far East Hotels and Entertainment Limited (HKG:37) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Far East Hotels and Entertainment

What Is Far East Hotels and Entertainment's Debt?

As you can see below, Far East Hotels and Entertainment had HK$23.6m of debt at September 2020, down from HK$25.9m a year prior. But it also has HK$45.5m in cash to offset that, meaning it has HK$21.9m net cash.

How Healthy Is Far East Hotels and Entertainment's Balance Sheet?

The latest balance sheet data shows that Far East Hotels and Entertainment had liabilities of HK$33.6m due within a year, and liabilities of HK$28.0m falling due after that. Offsetting this, it had HK$45.5m in cash and HK$10.7m in receivables that were due within 12 months. So it has liabilities totalling HK$5.45m more than its cash and near-term receivables, combined.

Of course, Far East Hotels and Entertainment has a market capitalization of HK$84.3m, so these liabilities are probably manageable. 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, Far East Hotels and Entertainment also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although Far East Hotels and Entertainment made a loss at the EBIT level, last year, it was also good to see that it generated HK$11m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Far East Hotels and Entertainment's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Far East Hotels and Entertainment 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. Over the last year, Far East Hotels and Entertainment reported free cash flow worth 19% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

We could understand if investors are concerned about Far East Hotels and Entertainment's liabilities, but we can be reassured by the fact it has has net cash of HK$21.9m. So we are not troubled with Far East Hotels and Entertainment's debt use. 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. For example, we've discovered 1 warning sign for Far East Hotels and Entertainment that you should be aware of before investing here.

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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