Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, GreenTree Hospitality Group Ltd. (NYSE:GHG) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
What Is GreenTree Hospitality Group's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2021 GreenTree Hospitality Group had debt of CN¥290.0m, up from CN¥70.0m in one year. But it also has CN¥1.02b in cash to offset that, meaning it has CN¥727.4m net cash.
How Healthy Is GreenTree Hospitality Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that GreenTree Hospitality Group had liabilities of CN¥1.06b due within 12 months and liabilities of CN¥997.9m due beyond that. On the other hand, it had cash of CN¥1.02b and CN¥445.0m worth of receivables due within a year. So it has liabilities totalling CN¥594.7m more than its cash and near-term receivables, combined.
Of course, GreenTree Hospitality Group has a market capitalization of CN¥5.38b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. 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.
And we also note warmly that GreenTree Hospitality Group grew its EBIT by 10% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine GreenTree Hospitality Group's ability to maintain a healthy balance sheet going forward. 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. 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. Looking at the most recent three years, GreenTree Hospitality Group recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While GreenTree Hospitality Group does have more liabilities than liquid assets, it also has net cash of CN¥727.4m. And it also grew its EBIT by 10% over the last year. So we don't have any problem with GreenTree Hospitality Group's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for GreenTree Hospitality Group (1 is a bit concerning!) that you should be aware of before investing here.
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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