Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Magnificent Hotel Investments Limited (HKG:201) does carry debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

Check out our latest analysis for Magnificent Hotel Investments

What Is Magnificent Hotel Investments's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Magnificent Hotel Investments had HK$399.1m of debt in June 2019, down from HK$692.9m, one year before. But it also has HK$512.4m in cash to offset that, meaning it has HK$113.3m net cash.

How Healthy Is Magnificent Hotel Investments's Balance Sheet?

We can see from the most recent balance sheet that Magnificent Hotel Investments had liabilities of HK$194.8m falling due within a year, and liabilities of HK$368.0m due beyond that. Offsetting these obligations, it had cash of HK$512.4m as well as receivables valued at HK$12.2m due within 12 months. So it has liabilities totalling HK$38.2m more than its cash and near-term receivables, combined.

Since publicly traded Magnificent Hotel Investments shares are worth a total of HK$1.45b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Magnificent Hotel Investments also has more cash than debt, so we're pretty confident it can manage its debt safely.

Fortunately, Magnificent Hotel Investments grew its EBIT by 6.6% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Magnificent Hotel Investments 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Magnificent Hotel Investments 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 last three years, Magnificent Hotel Investments actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

We could understand if investors are concerned about Magnificent Hotel Investments's liabilities, but we can be reassured by the fact it has has net cash of HK$113.3m. And it impressed us with free cash flow of HK$239m, being 124% of its EBIT. So is Magnificent Hotel Investments's debt a risk? It doesn't seem so to us. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Magnificent Hotel Investments's dividend history, without delay!

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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