Dalata Hotel Group (ISE:DHG) takes some risk with its use of debt
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Dalata Hotel Group plc (ISE:DHG) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we look at debt levels, we first consider cash and debt levels, together.
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What is the debt of Dalata Hotel Group?
The graph below, which you can click on for more details, shows that Dalata Hotel Group had a debt of 314.6 million euros in December 2021; about the same as the previous year. However, because it has a cash reserve of €41.1 million, its net debt is lower, at around €273.5 million.
How strong is Dalata Hotel Group’s balance sheet?
According to the latest published balance sheet, Dalata Hotel Group had liabilities of €94.9 million maturing within 12 months and liabilities of €837.7 million maturing beyond 12 months. In return, it had €41.1 million in cash and €9.74 million in receivables due within 12 months. Its liabilities therefore total €881.7 million more than the combination of its cash and short-term receivables.
That’s a mountain of leverage compared to its market capitalization of €959.4m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Dalata Hotel Group shareholders face the double whammy of a high net debt to EBITDA ratio (8.0) and quite low interest coverage, as EBIT is only 0.22 times interest charges. This means that we would consider him to be heavily indebted. However, the silver lining was that Dalata Hotel Group achieved a positive EBIT of EUR 7.3 million in the last twelve months, an improvement on the loss of the previous year. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Dalata Hotel Group can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of earnings before interest and tax (EBIT) is supported by free cash flow. Over the past year, Dalata Hotel Group has actually produced more free cash flow than EBIT. There’s nothing better than cash coming in to stay in your lenders’ good books.
Our point of view
Dalata Hotel Group’s interest coverage and net debt to EBITDA are definitely weighing on him, in our view. But its conversion of EBIT to free cash flow tells a very different story and suggests some resilience. When we consider all the factors discussed, it seems to us that Dalata Hotel Group is taking risks with its use of debt. While this debt may increase returns, we believe the company now has sufficient leverage. Even though Dalata Hotel Group lost money in net income, its positive EBIT suggests that the business itself has potential. You might want to check how income has changed over the past few years.
If you are interested in investing in businesses that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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