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. Importantly, GreenTree Hospitality Group Ltd. (NYSE:GHG) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is GreenTree Hospitality Group's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 GreenTree Hospitality Group had debt of CN¥150.0m, up from CN¥60.0m in one year. However, its balance sheet shows it holds CN¥1.16b in cash, so it actually has CN¥1.01b net cash.
How Healthy Is GreenTree Hospitality Group's Balance Sheet?
According to the last reported balance sheet, GreenTree Hospitality Group had liabilities of CN¥869.5m due within 12 months, and liabilities of CN¥975.5m due beyond 12 months. Offsetting this, it had CN¥1.16b in cash and CN¥333.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥355.8m.
Given GreenTree Hospitality Group has a market capitalization of CN¥5.76b, it's hard to believe these liabilities pose much threat. 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.
The modesty of its debt load may become crucial for GreenTree Hospitality Group if management cannot prevent a repeat of the 36% cut to EBIT over the last year. 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'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. During the last three years, GreenTree Hospitality Group produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. 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¥1.01b. The cherry on top was that in converted 67% of that EBIT to free cash flow, bringing in CN¥184m. 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. For instance, we've identified 2 warning signs for GreenTree Hospitality Group that you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
This article by Simply Wall St is general in nature. 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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