Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, Hubtown Limited (NSE:HUBTOWN) is in debt. But should shareholders worry about its use of debt?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for Hubtown
What is Hubtown’s net debt?
You can click on the chart below for historical figures, but it shows Hubtown had ₹6.78bn in debt in March 2022, up from ₹8.73bn a year prior. On the other hand, it has ₹559.5 million in cash, resulting in a net debt of around ₹6.22 billion.
How strong is Hubtown’s balance sheet?
We can see from the most recent balance sheet that Hubtown had liabilities of ₹31.1 billion due within a year, and liabilities of ₹2.87 billion due beyond. As compensation for these obligations, it had cash of ₹559.5 million as well as receivables valued at ₹3.41 billion due within 12 months. It therefore has liabilities totaling ₹30.0 billion more than its cash and short-term receivables, combined.
The deficiency here weighs heavily on society itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Hubtown would likely need a major recapitalization if its creditors were to demand repayment.
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). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Hubtown shareholders face the double whammy of a high net debt to EBITDA ratio (20.4) and fairly low interest coverage, as EBIT is only 0.30 times operating expenses. ‘interests. The debt burden here is considerable. Worse still, Hubtown’s EBIT was down 23% from a year ago. If earnings continue to follow this trajectory, paying off this debt will be more difficult than convincing us to run a marathon in the rain. When analyzing debt levels, the balance sheet is the obvious starting point. But it’s Hubtown’s earnings that will influence the balance sheet going forward. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Hubtown has actually had a cash outflow, overall. Debt is generally more expensive and almost always riskier in the hands of a company with negative free cash flow. Shareholders should hope for an improvement.
Our point of view
At first glance, Hubtown’s EBIT growth rate left us hesitant about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. And what’s more, its net debt to EBITDA also fails to inspire confidence. Considering everything we’ve mentioned above, it’s fair to say that Hubtown is heavily in debt. If you play with fire, you might get burned, so we’d probably give this stock a wide berth. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Hubtown (1 of which can’t be ignored!) that you should know about.
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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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.