These 4 Measures Indicate That Far East Hotels and Entertainment (HKG:37) Is Using Debt Reasonably Well

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. We note that Far East Hotels and Entertainment Limited (HKG:37) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Far East Hotels and Entertainment

What Is Far East Hotels and Entertainment's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Far East Hotels and Entertainment had HK$22.5m of debt in March 2021, down from HK$24.6m, one year before. But it also has HK$71.4m in cash to offset that, meaning it has HK$48.9m net cash.

How Strong 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$37.7m due within a year, and liabilities of HK$26.1m falling due after that. On the other hand, it had cash of HK$71.4m and HK$3.03m worth of receivables due within a year. So it actually has HK$10.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Far East Hotels and Entertainment could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Far East Hotels and Entertainment has more cash than debt is arguably a good indication that it can manage its debt safely.

Fortunately, Far East Hotels and Entertainment grew its EBIT by 6.0% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is Far East Hotels and Entertainment'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. While Far East Hotels and Entertainment 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 two years, Far East Hotels and Entertainment created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Far East Hotels and Entertainment has net cash of HK$48.9m, as well as more liquid assets than liabilities. And it also grew its EBIT by 6.0% over the last year. So we are not troubled with Far East Hotels and Entertainment's debt use. 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 Far East Hotels and Entertainment is showing 2 warning signs in our investment analysis , you should know about...

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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