David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that Elis SA (EPA:ELIS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Elis’s Debt?
The chart below, which you can click on for greater detail, shows that Elis had €3.54b in debt in December 2019; about the same as the year before. However, because it has a cash reserve of €172.3m, its net debt is less, at about €3.37b.
How Strong Is Elis’s Balance Sheet?
According to the last reported balance sheet, Elis had liabilities of €1.25b due within 12 months, and liabilities of €3.99b due beyond 12 months. Offsetting this, it had €172.3m in cash and €680.9m in receivables that were due within 12 months. So it has liabilities totalling €4.39b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the €1.83b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. After all, Elis would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Elis has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 2.7 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. However, one redeeming factor is that Elis grew its EBIT at 20% over the last 12 months, boosting its ability to handle 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 Elis 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Elis produced sturdy free cash flow equating to 56% 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.
Mulling over Elis’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Elis’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 3 warning signs for Elis you should be aware of, and 1 of them doesn’t sit too well with us.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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