Here's Why Lemon Tree Hotels (NSE:LEMONTREE) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Lemon Tree Hotels Limited (NSE:LEMONTREE) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. 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.

Check out our latest analysis for Lemon Tree Hotels

What Is Lemon Tree Hotels's Net Debt?

As you can see below, Lemon Tree Hotels had ₹21.8b of debt, at March 2023, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Lemon Tree Hotels' Balance Sheet?

We can see from the most recent balance sheet that Lemon Tree Hotels had liabilities of ₹3.70b falling due within a year, and liabilities of ₹19.5b due beyond that. Offsetting these obligations, it had cash of ₹284.8m as well as receivables valued at ₹559.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹22.3b.

This deficit isn't so bad because Lemon Tree Hotels is worth ₹80.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While we wouldn't worry about Lemon Tree Hotels's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 2.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Lemon Tree Hotels grew its EBIT by 211% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Lemon Tree 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 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 most recent two years, Lemon Tree Hotels recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On our analysis Lemon Tree Hotels's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, interest cover gives us cold feet. Considering this range of data points, we think Lemon Tree 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Lemon Tree Hotels has 1 warning sign we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.