Is Lemon Tree Hotels (NSE:LEMONTREE) Using Too Much Debt?

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.' 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 real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Debt?

The chart below, which you can click on for greater detail, shows that Lemon Tree Hotels had ₹17.0b in debt in March 2022; about the same as the year before. However, it also had ₹602.3m in cash, and so its net debt is ₹16.4b.

How Strong Is Lemon Tree Hotels' Balance Sheet?

The latest balance sheet data shows that Lemon Tree Hotels had liabilities of ₹2.53b due within a year, and liabilities of ₹19.8b falling due after that. Offsetting these obligations, it had cash of ₹602.3m as well as receivables valued at ₹290.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹21.5b.

While this might seem like a lot, it is not so bad since Lemon Tree Hotels has a market capitalization of ₹52.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Lemon Tree Hotels shareholders face the double whammy of a high net debt to EBITDA ratio (12.2), and fairly weak interest coverage, since EBIT is just 0.17 times the interest expense. The debt burden here is substantial. One redeeming factor for Lemon Tree Hotels is that it turned last year's EBIT loss into a gain of ₹296m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Lemon Tree Hotels actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither Lemon Tree Hotels's ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Lemon Tree Hotels is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Case in point: We've spotted 1 warning sign for Lemon Tree Hotels you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.