Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, PPHE Hotel Group Limited (LON:PPH) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does PPHE Hotel Group Carry?
As you can see below, PPHE Hotel Group had UK£697.5m of debt at December 2018, down from UK£892.3m a year prior. However, it does have UK£212.1m in cash offsetting this, leading to net debt of about UK£485.4m.
How Strong Is PPHE Hotel Group's Balance Sheet?
The latest balance sheet data shows that PPHE Hotel Group had liabilities of UK£68.9m due within a year, and liabilities of UK£1.01b falling due after that. Offsetting this, it had UK£212.1m in cash and UK£18.9m in receivables that were due within 12 months. So its liabilities total UK£852.6m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of UK£746.2m, we think shareholders really should watch PPHE Hotel Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.
PPHE Hotel Group's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 2.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fortunately, PPHE Hotel Group grew its EBIT by 5.8% in the last year, slowly shrinking its debt relative to earnings. 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 PPHE 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, PPHE Hotel Group burned a lot of cash. 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 PPHE Hotel Group's conversion of EBIT to free cash flow was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. We're quite clear that we consider PPHE Hotel Group to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of PPHE Hotel Group's earnings per share history for free.
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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