Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Banyan Tree Holdings Limited (SGX:B58) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Banyan Tree Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that Banyan Tree Holdings had S$459.8m of debt in June 2019, down from S$707.9m, one year before. However, because it has a cash reserve of S$54.0m, its net debt is less, at about S$405.8m.
A Look At Banyan Tree Holdings's Liabilities
We can see from the most recent balance sheet that Banyan Tree Holdings had liabilities of S$461.8m falling due within a year, and liabilities of S$416.2m due beyond that. Offsetting this, it had S$54.0m in cash and S$79.6m in receivables that were due within 12 months. So its liabilities total S$744.4m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the S$407.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Banyan Tree Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.24 times and a disturbingly high net debt to EBITDA ratio of 12.3 hit our confidence in Banyan Tree Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Notably, Banyan Tree Holdings's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 Banyan Tree Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Banyan Tree Holdings 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.
To be frank both Banyan Tree Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Considering all the factors previously mentioned, we think that Banyan Tree Holdings really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. While Banyan Tree Holdings didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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