Lemon Tree Hotels (NSE:LEMONTREE) Seems To Be Using A Lot 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 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. As with many other companies Lemon Tree Hotels Limited (NSE:LEMONTREE) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Lemon Tree Hotels

What Is Lemon Tree Hotels's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Lemon Tree Hotels had ₹15.5b of debt, an increase on ₹12.9b, over one year. However, it does have ₹2.21b in cash offsetting this, leading to net debt of about ₹13.3b.

A Look At Lemon Tree Hotels' Liabilities

Zooming in on the latest balance sheet data, we can see that Lemon Tree Hotels had liabilities of ₹3.48b due within 12 months and liabilities of ₹19.2b due beyond that. Offsetting these obligations, it had cash of ₹2.21b as well as receivables valued at ₹291.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹20.2b.

This deficit is considerable relative to its market capitalization of ₹31.7b, so it does suggest shareholders should keep an eye on Lemon Tree Hotels' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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 (9.5), and fairly weak interest coverage, since EBIT is just 0.29 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Lemon Tree Hotels's EBIT was down 57% 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. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Lemon Tree Hotels burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Lemon Tree Hotels's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. After considering the datapoints discussed, we think Lemon Tree Hotels 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. To that end, you should be aware of the 3 warning signs we've spotted with Lemon Tree Hotels .

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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