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 Green World Hotels Co., Ltd. (GTSM:8077) does have debt on its balance sheet. 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. 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. 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.
What Is Green World Hotels's Debt?
As you can see below, Green World Hotels had NT$350.0m of debt at September 2020, down from NT$390.0m a year prior. However, it also had NT$336.7m in cash, and so its net debt is NT$13.3m.
How Strong Is Green World Hotels' Balance Sheet?
We can see from the most recent balance sheet that Green World Hotels had liabilities of NT$751.9m falling due within a year, and liabilities of NT$2.81b due beyond that. Offsetting this, it had NT$336.7m in cash and NT$15.9m in receivables that were due within 12 months. So it has liabilities totalling NT$3.21b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the NT$965.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Green World Hotels would likely require a major re-capitalisation if it had to pay its creditors today. Green World Hotels has a very little net debt but plenty of other liabilities weighing it down. There's no doubt that we learn most about debt from the balance sheet. But it is Green World Hotels'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.
Over 12 months, Green World Hotels made a loss at the EBIT level, and saw its revenue drop to NT$657m, which is a fall of 46%. That makes us nervous, to say the least.
While Green World Hotels's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable NT$208m at the EBIT level. Combining this information with the significant liabilities we already touched on makes us very hesitant about this stock, to say the least. Of course, it may be able to improve its situation with a bit of luck and good execution. But we think that is unlikely since it is low on liquid assets, and made a loss of NT$743m in the last year. So while it's not wise to assume the company will fail, we do think it's risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Green World Hotels (including 1 which makes us a bit uncomfortable) .
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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