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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that The Indian Hotels Company Limited (NSE:INDHOTEL) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Indian Hotels’s Debt?
As you can see below, Indian Hotels had ₹15.5b of debt at September 2019, down from ₹24.0b a year prior. However, it does have ₹4.61b in cash offsetting this, leading to net debt of about ₹10.9b.
How Strong Is Indian Hotels’s Balance Sheet?
We can see from the most recent balance sheet that Indian Hotels had liabilities of ₹23.4b falling due within a year, and liabilities of ₹38.5b due beyond that. On the other hand, it had cash of ₹4.61b and ₹3.32b worth of receivables due within a year. So its liabilities total ₹54.0b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Indian Hotels is worth ₹95.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Indian Hotels has a very low debt to EBITDA ratio of 1.0 so it is strange to see weak interest coverage, with last year’s EBIT being only 2.4 times the interest expense. So while we’re not necessarily alarmed we think that its debt is far from trivial. Importantly, Indian Hotels grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Indian Hotels 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Indian Hotels’s free cash flow amounted to 35% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
On our analysis Indian Hotels’s EBIT growth rate should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. In particular, interest cover gives us cold feet. Looking at all this data makes us feel a little cautious about Indian Hotels’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 example, we’ve discovered 3 warning signs for Indian Hotels (1 is 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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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