Dechra Pharmaceuticals (LON:DPH) Has A Pretty Healthy Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Dechra Pharmaceuticals PLC (LON:DPH) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Dechra Pharmaceuticals

How Much Debt Does Dechra Pharmaceuticals Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Dechra Pharmaceuticals had debt of UK£327.2m, up from UK£293.6m in one year. However, it also had UK£139.0m in cash, and so its net debt is UK£188.2m.

A Look At Dechra Pharmaceuticals' Liabilities

Zooming in on the latest balance sheet data, we can see that Dechra Pharmaceuticals had liabilities of UK£133.1m due within 12 months and liabilities of UK£447.4m due beyond that. On the other hand, it had cash of UK£139.0m and UK£91.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£350.3m.

Of course, Dechra Pharmaceuticals has a market capitalization of UK£3.66b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Dechra Pharmaceuticals's net debt of 1.8 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.3 times its interest expenses harmonizes with that theme. Importantly, Dechra Pharmaceuticals grew its EBIT by 33% over the last twelve months, and that growth will make it easier 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 Dechra Pharmaceuticals 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Dechra Pharmaceuticals recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Dechra Pharmaceuticals's impressive EBIT growth rate implies it has the upper hand on its debt. And its interest cover is good too. Taking all this data into account, it seems to us that Dechra Pharmaceuticals takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Dechra Pharmaceuticals you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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