Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Trip.com Group Limited (NASDAQ:TCOM) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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 Trip.com Group’s Net Debt?

As you can see below, Trip.com Group had CN¥63.7b of debt at June 2021, down from CN¥70.2b a year prior. However, it does have CN¥63.0b in cash offsetting this, leading to net debt of about CN¥698.0m.

A Look At Trip.com Group’s Liabilities

According to the last reported balance sheet, Trip.com Group had liabilities of CN¥68.6b due within 12 months, and liabilities of CN¥27.1b due beyond 12 months. On the other hand, it had cash of CN¥63.0b and CN¥5.34b worth of receivables due within a year. So it has liabilities totalling CN¥27.4b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Trip.com Group has a huge market capitalization of CN¥118.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Carrying virtually no net debt, Trip.com Group has a very light debt load indeed.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Trip.com Group has a low debt to EBITDA ratio of only 0.44. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there’s no doubt this company can take on debt while staying cool as a cucumber. The modesty of its debt load may become crucial for Trip.com Group if management cannot prevent a repeat of the 50% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Trip.com Group’s ability to maintain a healthy balance sheet going forward.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Trip.com Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Trip.com Group’s impressive interest cover implies it has the upper hand on its debt. But we must concede we find its EBIT growth rate has the opposite effect. All these things considered, it appears that Trip.com Group can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start.