We Think Dechra Pharmaceuticals (LON:DPH) Is Taking Some Risk With Its Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Dechra Pharmaceuticals PLC (LON:DPH) does carry debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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, 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.

View our latest analysis for Dechra Pharmaceuticals

What Is Dechra Pharmaceuticals's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Dechra Pharmaceuticals had debt of UK£520.1m, up from UK£301.4m in one year. However, because it has a cash reserve of UK£87.9m, its net debt is less, at about UK£432.2m.

A Look At Dechra Pharmaceuticals' Liabilities

According to the last reported balance sheet, Dechra Pharmaceuticals had liabilities of UK£168.4m due within 12 months, and liabilities of UK£734.2m due beyond 12 months. Offsetting this, it had UK£87.9m in cash and UK£147.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£667.1m.

While this might seem like a lot, it is not so bad since Dechra Pharmaceuticals has a market capitalization of UK£3.10b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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 has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The bad news is that Dechra Pharmaceuticals saw its EBIT decline by 18% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Dechra Pharmaceuticals created free cash flow amounting to 20% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Mulling over Dechra Pharmaceuticals's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Once we consider all the factors above, together, it seems to us that Dechra Pharmaceuticals's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Dechra Pharmaceuticals (including 1 which is significant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.