Is ECO Animal Health Group (LON:EAH) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 ECO Animal Health Group plc (LON:EAH) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ECO Animal Health Group

What Is ECO Animal Health Group's Debt?

As you can see below, at the end of September 2020, ECO Animal Health Group had UK£4.12m of debt, up from none a year ago. Click the image for more detail. However, its balance sheet shows it holds UK£17.1m in cash, so it actually has UK£12.9m net cash.

How Healthy Is ECO Animal Health Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ECO Animal Health Group had liabilities of UK£20.9m due within 12 months and liabilities of UK£1.89m due beyond that. On the other hand, it had cash of UK£17.1m and UK£30.4m worth of receivables due within a year. So it can boast UK£24.7m more liquid assets than total liabilities.

This short term liquidity is a sign that ECO Animal Health Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, ECO Animal Health Group boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, ECO Animal Health Group saw its EBIT drop by 3.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 ECO Animal Health Group 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. While ECO Animal Health Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, ECO Animal Health Group recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case ECO Animal Health Group has UK£12.9m in net cash and a decent-looking balance sheet. So we don't have any problem with ECO Animal Health Group's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for ECO Animal Health Group (1 is a bit unpleasant!) that you should be aware of before investing here.

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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This article by Simply Wall St is general in nature. 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.
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