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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. Importantly, Royal Orchid Hotels Limited (NSE:ROHLTD) does carry debt. But is this debt a concern to shareholders?
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. 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. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Royal Orchid Hotels
How Much Debt Does Royal Orchid Hotels Carry?
As you can see below, Royal Orchid Hotels had ₹913.4m of debt at March 2019, down from ₹1.07b a year prior. On the flip side, it has ₹446.9m in cash leading to net debt of about ₹466.6m.
A Look At Royal Orchid Hotels's Liabilities
Zooming in on the latest balance sheet data, we can see that Royal Orchid Hotels had liabilities of ₹873.9m due within 12 months and liabilities of ₹944.8m due beyond that. Offsetting this, it had ₹446.9m in cash and ₹216.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.16b.
While this might seem like a lot, it is not so bad since Royal Orchid Hotels has a market capitalization of ₹2.22b, 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.
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.
Given net debt is only 1.4 times EBITDA, it is initially surprising to see that Royal Orchid Hotels's EBIT has low interest coverage of 1.3 times. So one way or the other, it's clear the debt levels are not trivial. Importantly Royal Orchid Hotels's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Royal Orchid 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.