Does Elementis (LON:ELM) Have A Healthy Balance Sheet?

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.' 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. We note that Elementis plc (LON:ELM) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Elementis

How Much Debt Does Elementis Carry?

As you can see below, Elementis had US$319.0m of debt at June 2023, down from US$468.5m a year prior. However, it does have US$67.3m in cash offsetting this, leading to net debt of about US$251.7m.

How Strong Is Elementis' Balance Sheet?

We can see from the most recent balance sheet that Elementis had liabilities of US$136.7m falling due within a year, and liabilities of US$510.2m due beyond that. Offsetting these obligations, it had cash of US$67.3m as well as receivables valued at US$121.2m due within 12 months. So it has liabilities totalling US$458.4m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Elementis has a market capitalization of US$788.5m, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Elementis has net debt worth 1.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.0 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Elementis's EBIT shot up like bamboo after rain, gaining 87% 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 it is future earnings, more than anything, that will determine Elementis's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Elementis recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Elementis's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Elementis's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that Elementis 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, 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.