The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Asian Hotels (West) Limited (NSE:AHLWEST) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Asian Hotels (West)'s Debt?
As you can see below, Asian Hotels (West) had ₹7.60b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₹569.2m in cash, and so its net debt is ₹7.03b.
A Look At Asian Hotels (West)'s Liabilities
We can see from the most recent balance sheet that Asian Hotels (West) had liabilities of ₹1.02b falling due within a year, and liabilities of ₹9.71b due beyond that. Offsetting this, it had ₹569.2m in cash and ₹122.5m in receivables that were due within 12 months. So it has liabilities totalling ₹10.0b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the ₹2.86b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Asian Hotels (West) would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Weak interest cover of 0.41 times and a disturbingly high net debt to EBITDA ratio of 8.3 hit our confidence in Asian Hotels (West) like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Asian Hotels (West) saw its EBIT tank 72% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Asian Hotels (West)'s earnings that will influence how the balance sheet holds up in the future. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Asian Hotels (West) actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
To be frank both Asian Hotels (West)'s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Asian Hotels (West) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Take risks, for example - Asian Hotels (West) has 2 warning signs (and 1 which can't be ignored) we think you should know about.
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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