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.' 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. We note that Elanor Investors Group (ASX:ENN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Elanor Investors Group
What Is Elanor Investors Group's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Elanor Investors Group had debt of AU$288.3m, up from AU$255.5m in one year. However, because it has a cash reserve of AU$42.5m, its net debt is less, at about AU$245.8m.
How Strong Is Elanor Investors Group's Balance Sheet?
The latest balance sheet data shows that Elanor Investors Group had liabilities of AU$109.4m due within a year, and liabilities of AU$204.0m falling due after that. Offsetting this, it had AU$42.5m in cash and AU$13.7m in receivables that were due within 12 months. So its liabilities total AU$257.1m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's AU$201.0m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). 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).
Weak interest cover of 0.62 times and a disturbingly high net debt to EBITDA ratio of 11.3 hit our confidence in Elanor Investors Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Another concern for investors might be that Elanor Investors Group's EBIT fell 11% 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 ultimately the future profitability of the business will decide if Elanor Investors Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Elanor Investors Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
On the face of it, Elanor Investors Group's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. We think the chances that Elanor Investors Group has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Elanor Investors Group that you should be aware of before investing here.
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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About ASX:ENN
Moderate and slightly overvalued.