Is Hotel NewgrandLtd (TYO:9720) Using Debt In A Risky Way?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hotel Newgrand Co.,Ltd. (TYO:9720) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Hotel NewgrandLtd

What Is Hotel NewgrandLtd's Debt?

The image below, which you can click on for greater detail, shows that at February 2021 Hotel NewgrandLtd had debt of JP¥3.62b, up from JP¥2.79b in one year. However, it also had JP¥486.0m in cash, and so its net debt is JP¥3.14b.

A Look At Hotel NewgrandLtd's Liabilities

The latest balance sheet data shows that Hotel NewgrandLtd had liabilities of JP¥2.21b due within a year, and liabilities of JP¥3.65b falling due after that. Offsetting these obligations, it had cash of JP¥486.0m as well as receivables valued at JP¥128.0m due within 12 months. So its liabilities total JP¥5.25b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's JP¥4.49b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hotel NewgrandLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Hotel NewgrandLtd made a loss at the EBIT level, and saw its revenue drop to JP¥2.6b, which is a fall of 50%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Hotel NewgrandLtd's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost a very considerable JP¥1.1b at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it burned through JP¥839m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Hotel NewgrandLtd (1 is a bit concerning) you should be aware of.

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. 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.
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