Here's Why Hotel Grand Central (SGX:H18) Can Manage Its Debt Responsibly

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. As with many other companies Hotel Grand Central Limited (SGX:H18) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hotel Grand Central

How Much Debt Does Hotel Grand Central Carry?

You can click the graphic below for the historical numbers, but it shows that Hotel Grand Central had S$27.7m of debt in December 2020, down from S$53.3m, one year before. But it also has S$229.0m in cash to offset that, meaning it has S$201.3m net cash.

How Healthy Is Hotel Grand Central's Balance Sheet?

The latest balance sheet data shows that Hotel Grand Central had liabilities of S$47.9m due within a year, and liabilities of S$147.7m falling due after that. Offsetting this, it had S$229.0m in cash and S$9.07m in receivables that were due within 12 months. So it actually has S$42.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Hotel Grand Central could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Hotel Grand Central boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Hotel Grand Central if management cannot prevent a repeat of the 64% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hotel Grand Central will need earnings to service that debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. Hotel Grand Central 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. During the last three years, Hotel Grand Central produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Hotel Grand Central has net cash of S$201.3m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of S$10m, being 70% of its EBIT. So we are not troubled with Hotel Grand Central's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Hotel Grand Central (1 is a bit concerning) you should be aware of.

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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