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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Far East Hotels and Entertainment Limited (HKG:37) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Far East Hotels and Entertainment

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

As you can see below, Far East Hotels and Entertainment had HK$21.4m of debt at September 2021, down from HK$23.6m a year prior. However, its balance sheet shows it holds HK$50.1m in cash, so it actually has HK$28.7m 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$32.6m due within a year, and liabilities of HK$20.5m falling due after that. Offsetting these obligations, it had cash of HK$50.1m as well as receivables valued at HK$12.2m due within 12 months. So it can boast HK$9.24m more liquid assets than total liabilities.

This surplus suggests that Far East Hotels and Entertainment has a conservative balance sheet, and could probably eliminate its debt without much difficulty. 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.

It is just as well that Far East Hotels and Entertainment's load is not too heavy, because its EBIT was down 50% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 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, while the tax-man may adore accounting profits, lenders only accept 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 two years, Far East Hotels and Entertainment recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While it is always sensible to investigate a company's debt, in this case Far East Hotels and Entertainment has HK$28.7m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in HK$5.3m. 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. We've identified 4 warning signs with Far East Hotels and Entertainment , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.