Chalet Hotels (NSE:CHALET) Takes On Some Risk With Its Use Of Debt

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.' 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 Chalet Hotels Limited (NSE:CHALET) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Chalet Hotels

What Is Chalet Hotels's Net Debt?

As you can see below, at the end of September 2020, Chalet Hotels had ₹19.6b of debt, up from ₹15.7b a year ago. Click the image for more detail. On the flip side, it has ₹517.0m in cash leading to net debt of about ₹19.1b.

How Healthy Is Chalet Hotels's Balance Sheet?

The latest balance sheet data shows that Chalet Hotels had liabilities of ₹8.50b due within a year, and liabilities of ₹16.0b falling due after that. Offsetting these obligations, it had cash of ₹517.0m as well as receivables valued at ₹229.5m due within 12 months. So it has liabilities totalling ₹23.7b more than its cash and near-term receivables, combined.

Chalet Hotels has a market capitalization of ₹40.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Chalet Hotels shareholders face the double whammy of a high net debt to EBITDA ratio (9.7), and fairly weak interest coverage, since EBIT is just 0.58 times the interest expense. The debt burden here is substantial. Worse, Chalet Hotels's EBIT was down 70% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Chalet Hotels can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Chalet Hotels actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Chalet Hotels's interest cover and its track record of (not) growing its EBIT 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. Once we consider all the factors above, together, it seems to us that Chalet Hotels's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Take risks, for example - Chalet Hotels has 1 warning sign we think you should be aware of.

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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