We Think Lemon Tree Hotels (NSE:LEMONTREE) Can Stay On Top Of Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Lemon Tree Hotels Limited (NSE:LEMONTREE) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out the opportunities and risks within the IN Hospitality industry.

What Is Lemon Tree Hotels's Net Debt?

As you can see below, Lemon Tree Hotels had ₹16.8b of debt, at September 2022, 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 ₹2.58b falling due within a year, and liabilities of ₹19.7b due beyond that. Offsetting these obligations, it had cash of ₹224.1m as well as receivables valued at ₹527.0m due within 12 months. So it has liabilities totalling ₹21.5b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Lemon Tree Hotels has a market capitalization of ₹78.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.98 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Lemon Tree Hotels like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Lemon Tree Hotels achieved a positive EBIT of ₹1.7b in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Lemon Tree Hotels's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Lemon Tree Hotels recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Lemon Tree Hotels's interest cover was a real negative on this analysis, as was its net debt to EBITDA. But its conversion of EBIT to free cash flow was significantly redeeming. Looking at all this data makes us feel a little cautious about Lemon Tree Hotels's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Lemon Tree Hotels has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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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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.