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. As with many other companies Elanor Investors Group (ASX:ENN) makes use of 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Elanor Investors Group's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2021 Elanor Investors Group had debt of AU$312.3m, up from AU$286.5m in one year. However, it also had AU$25.7m in cash, and so its net debt is AU$286.7m.
How Strong Is Elanor Investors Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Elanor Investors Group had liabilities of AU$112.4m due within 12 months and liabilities of AU$244.4m due beyond that. Offsetting this, it had AU$25.7m in cash and AU$9.62m in receivables that were due within 12 months. So it has liabilities totalling AU$321.5m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of AU$216.2m, we think shareholders really should watch Elanor Investors Group's debt levels, like a parent watching their child ride a bike for the first time. 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Elanor Investors Group shareholders face the double whammy of a high net debt to EBITDA ratio (14.7), and fairly weak interest coverage, since EBIT is just 0.58 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that Elanor Investors Group actually let its EBIT decrease by 5.1% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 Elanor Investors Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Elanor Investors Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
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 furthermore, its level of total liabilities also fails to instill 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. Be aware that Elanor Investors Group is showing 3 warning signs in our investment analysis , and 2 of those are concerning...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.