We Think Formosa International Hotels (TPE:2707) Can Stay On Top Of Its Debt

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Formosa International Hotels Corporation (TPE:2707) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Formosa International Hotels

What Is Formosa International Hotels's Net Debt?

As you can see below, Formosa International Hotels had NT$1.41b of debt at December 2020, down from NT$1.83b a year prior. But it also has NT$2.36b in cash to offset that, meaning it has NT$955.7m net cash.

How Healthy Is Formosa International Hotels' Balance Sheet?

We can see from the most recent balance sheet that Formosa International Hotels had liabilities of NT$3.62b falling due within a year, and liabilities of NT$3.69b due beyond that. Offsetting these obligations, it had cash of NT$2.36b as well as receivables valued at NT$610.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.33b.

While this might seem like a lot, it is not so bad since Formosa International Hotels has a market capitalization of NT$19.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Formosa International Hotels boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Formosa International Hotels's load is not too heavy, because its EBIT was down 42% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Formosa International Hotels 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Formosa International Hotels 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. Happily for any shareholders, Formosa International Hotels actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

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$955.7m. And it impressed us with free cash flow of NT$764m, being 125% of its EBIT. So we are not troubled with Formosa International Hotels'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. For example, we've discovered 2 warning signs for Formosa International Hotels that you should be aware of before investing here.

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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