Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Elanco Animal Health Incorporated (NYSE:ELAN) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Elanco Animal Health’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Elanco Animal Health had US$2.47b of debt, an increase on none, over one year. On the flip side, it has US$272.1m in cash leading to net debt of about US$2.19b.
How Strong Is Elanco Animal Health’s Balance Sheet?
We can see from the most recent balance sheet that Elanco Animal Health had liabilities of US$708.2m falling due within a year, and liabilities of US$2.84b due beyond that. On the other hand, it had cash of US$272.1m and US$827.4m worth of receivables due within a year. So it has liabilities totalling US$2.45b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Elanco Animal Health has a huge market capitalization of US$10.9b, 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt to EBITDA of 3.3 Elanco Animal Health has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.2 times its interest expense, and its net debt to EBITDA, was quite high, at 3.3. It is well worth noting that Elanco Animal Health’s EBIT shot up like bamboo after rain, gaining 78% in the last twelve months. That’ll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Elanco Animal Health can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Elanco Animal Health produced sturdy free cash flow equating to 51% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Elanco Animal Health’s EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Elanco Animal Health can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. We’d be motivated to research the stock further if we found out that Elanco Animal Health insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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