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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Dalata Hotel Group plc (ISE:DHG) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
What Is Dalata Hotel Group's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Dalata Hotel Group had debt of €401.8m, up from €298.1m in one year. However, because it has a cash reserve of €45.9m, its net debt is less, at about €356.0m.
How Healthy Is Dalata Hotel Group's Balance Sheet?
We can see from the most recent balance sheet that Dalata Hotel Group had liabilities of €103.6m falling due within a year, and liabilities of €744.2m due beyond that. Offsetting this, it had €45.9m in cash and €21.7m in receivables that were due within 12 months. So its liabilities total €780.1m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of €895.5m, so it does suggest shareholders should keep an eye on Dalata Hotel Group's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Dalata Hotel Group has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 5.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Dalata Hotel Group could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 18%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dalata Hotel Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Dalata Hotel Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
We'd go so far as to say Dalata Hotel Group's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Dalata Hotel Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.