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.' 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. As with many other companies The ONE Group Hospitality, Inc. (NASDAQ:STKS) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does ONE Group Hospitality Carry?
The image below, which you can click on for greater detail, shows that ONE Group Hospitality had debt of US$55.4m at the end of June 2021, a reduction from US$64.0m over a year. However, because it has a cash reserve of US$41.4m, its net debt is less, at about US$14.0m.
How Strong Is ONE Group Hospitality's Balance Sheet?
The latest balance sheet data shows that ONE Group Hospitality had liabilities of US$50.2m due within a year, and liabilities of US$141.4m falling due after that. Offsetting this, it had US$41.4m in cash and US$6.95m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$143.2m.
ONE Group Hospitality has a market capitalization of US$377.6m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While ONE Group Hospitality's low debt to EBITDA ratio of 0.55 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that ONE Group Hospitality improved its EBIT from a last year's loss to a positive US$15m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ONE Group Hospitality can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, ONE Group Hospitality actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
When it comes to the balance sheet, the standout positive for ONE Group Hospitality was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that ONE Group Hospitality is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example ONE Group Hospitality has 5 warning signs (and 1 which is significant) we think you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
What are the risks and opportunities for ONE Group Hospitality?
Price-To-Earnings ratio (17x) is below the Hospitality industry average (19.2x)
Earnings are forecast to grow 44.86% per year
High level of non-cash earnings
Profit margins (4.6%) are lower than last year (8.9%)
Volatile share price over the past 3 months
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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