These 4 Measures Indicate That Formosa International Hotels (TPE:2707) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Formosa International Hotels Corporation (TPE:2707) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Formosa International Hotels

What Is Formosa International Hotels's Debt?

The image below, which you can click on for greater detail, shows that Formosa International Hotels had debt of NT$1.40b at the end of September 2020, a reduction from NT$1.84b over a year. But on the other hand it also has NT$1.98b in cash, leading to a NT$581.2m net cash position.

How Strong Is Formosa International Hotels' Balance Sheet?

The latest balance sheet data shows that Formosa International Hotels had liabilities of NT$3.48b due within a year, and liabilities of NT$3.77b falling due after that. Offsetting these obligations, it had cash of NT$1.98b as well as receivables valued at NT$585.5m due within 12 months. So it has liabilities totalling NT$4.68b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Formosa International Hotels has a market capitalization of NT$16.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Formosa International Hotels also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Formosa International Hotels's saving grace is its low debt levels, because its EBIT has tanked 37% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Formosa International Hotels's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Formosa International Hotels 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, Formosa International Hotels actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although Formosa International Hotels's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NT$581.2m. The cherry on top was that in converted 143% of that EBIT to free cash flow, bringing in NT$2.2b. So we don't have any problem with Formosa International Hotels's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Formosa International Hotels is showing 3 warning signs in our investment analysis , you should know about...

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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