Warren Buffett famously said, '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 GreenTree Hospitality Group Ltd. (NYSE:GHG) makes use of debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.
What Is GreenTree Hospitality Group's Debt?
The chart below, which you can click on for greater detail, shows that GreenTree Hospitality Group had CN¥60.0m in debt in September 2020; about the same as the year before. But on the other hand it also has CN¥954.6m in cash, leading to a CN¥894.6m net cash position.
How Strong Is GreenTree Hospitality Group's Balance Sheet?
We can see from the most recent balance sheet that GreenTree Hospitality Group had liabilities of CN¥783.9m falling due within a year, and liabilities of CN¥1.02b due beyond that. Offsetting these obligations, it had cash of CN¥954.6m as well as receivables valued at CN¥331.2m due within 12 months. So its liabilities total CN¥513.4m more than the combination of its cash and short-term receivables.
Of course, GreenTree Hospitality Group has a market capitalization of CN¥8.75b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, GreenTree Hospitality Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
In fact GreenTree Hospitality Group's saving grace is its low debt levels, because its EBIT has tanked 44% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if GreenTree Hospitality Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. GreenTree Hospitality Group 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. Over the most recent three years, GreenTree Hospitality Group recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
We could understand if investors are concerned about GreenTree Hospitality Group's liabilities, but we can be reassured by the fact it has has net cash of CN¥894.6m. And it impressed us with free cash flow of CN¥58m, being 72% of its EBIT. So we are not troubled with GreenTree Hospitality Group's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for GreenTree Hospitality Group you should be aware of.
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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