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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. We note that The Indian Hotels Company Limited (NSE:INDHOTEL) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Indian Hotels’s Debt?
The image below, which you can click on for greater detail, shows that Indian Hotels had debt of ₹23.3b at the end of March 2019, a reduction from ₹24.3b over a year. However, because it has a cash reserve of ₹4.52b, its net debt is less, at about ₹18.7b.
How Healthy Is Indian Hotels’s Balance Sheet?
The latest balance sheet data shows that Indian Hotels had liabilities of ₹20.9b due within a year, and liabilities of ₹23.5b falling due after that. On the other hand, it had cash of ₹4.52b and ₹4.25b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹35.6b.
Indian Hotels has a market capitalization of ₹174.3b, so it could very likely ameliorate 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. Either way, since Indian Hotels does have more debt than cash, it’s worth keeping an eye on its balance sheet.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Indian Hotels has net debt worth 2.12 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.03 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Importantly, Indian Hotels grew its EBIT by 34% over the last twelve months, and that growth will make it easier to handle its debt. 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 Indian Hotels’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Indian Hotels’s free cash flow amounted to 26% 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. For example, its interest cover makes us a little nervous about its debt. Considering this range of data points, we think Indian Hotels is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you’re interested in Indian Hotels, you may well want to click here to check an interactive graph of its earnings per share history.
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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