David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Lordos Hotels (Holdings) Public Limited (CSE:LHH) makes use of debt. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Lordos Hotels (Holdings)'s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Lordos Hotels (Holdings) had €6.30m of debt, an increase on €188.9k, over one year. Net debt is about the same, since the it doesn't have much cash.
How Strong Is Lordos Hotels (Holdings)'s Balance Sheet?
The latest balance sheet data shows that Lordos Hotels (Holdings) had liabilities of €3.83m due within a year, and liabilities of €19.7m falling due after that. Offsetting this, it had €19.7k in cash and €807.2k in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €22.7m.
When you consider that this deficiency exceeds the company's €20.5m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt to EBITDA of 2.8 Lordos Hotels (Holdings) has a fairly noticeable amount of debt. But the high interest coverage of 7.0 suggests it can easily service that debt. Shareholders should be aware that Lordos Hotels (Holdings)'s EBIT was down 75% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Lordos Hotels (Holdings) 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Lordos Hotels (Holdings) produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
We'd go so far as to say Lordos Hotels (Holdings)'s EBIT growth rate was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Lordos Hotels (Holdings) has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Lordos Hotels (Holdings) that you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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