Here's Why Nan Ren Lake Leisure Amusement (GTSM:5905) 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. We note that Nan Ren Lake Leisure Amusement Co., Ltd. (GTSM:5905) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Nan Ren Lake Leisure Amusement

How Much Debt Does Nan Ren Lake Leisure Amusement Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Nan Ren Lake Leisure Amusement had debt of NT$606.4m, up from NT$203.3m in one year. But it also has NT$1.29b in cash to offset that, meaning it has NT$680.0m net cash.

How Strong Is Nan Ren Lake Leisure Amusement's Balance Sheet?

The latest balance sheet data shows that Nan Ren Lake Leisure Amusement had liabilities of NT$1.16b due within a year, and liabilities of NT$124.4m falling due after that. Offsetting these obligations, it had cash of NT$1.29b as well as receivables valued at NT$97.6m due within 12 months. So it actually has NT$103.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Nan Ren Lake Leisure Amusement could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Nan Ren Lake Leisure Amusement has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Nan Ren Lake Leisure Amusement's load is not too heavy, because its EBIT was down 98% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Nan Ren Lake Leisure Amusement 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Nan Ren Lake Leisure Amusement 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. Over the last three years, Nan Ren Lake Leisure Amusement actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While it is always sensible to investigate a company's debt, in this case Nan Ren Lake Leisure Amusement has NT$680.0m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 531% of that EBIT to free cash flow, bringing in -NT$78m. So we are not troubled with Nan Ren Lake Leisure Amusement's debt use. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Nan Ren Lake Leisure Amusement (at least 1 which is concerning) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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