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.' 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. We can see that Hotel Royal Limited (SGX:H12) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hotel Royal

What Is Hotel Royal's Debt?

You can click the graphic below for the historical numbers, but it shows that Hotel Royal had S$113.5m of debt in March 2019, down from S$151.4m, one year before. However, it does have S$37.8m in cash offsetting this, leading to net debt of about S$75.7m.

A Look At Hotel Royal's Liabilities

The latest balance sheet data shows that Hotel Royal had liabilities of S$18.9m due within a year, and liabilities of S$126.0m falling due after that. On the other hand, it had cash of S$37.8m and S$12.1m worth of receivables due within a year. So it has liabilities totalling S$94.9m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Hotel Royal is worth S$318.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Hotel Royal has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 3.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Another concern for investors might be that Hotel Royal's EBIT fell 13% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hotel Royal's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.