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.' 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, Phibro Animal Health Corporation (NASDAQ:PAHC) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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.
What Is Phibro Animal Health's Debt?
As you can see below, Phibro Animal Health had US$383.5m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$93.1m, its net debt is less, at about US$290.4m.
How Healthy Is Phibro Animal Health's Balance Sheet?
According to the last reported balance sheet, Phibro Animal Health had liabilities of US$168.9m due within 12 months, and liabilities of US$420.2m due beyond 12 months. Offsetting this, it had US$93.1m in cash and US$135.6m in receivables that were due within 12 months. So it has liabilities totalling US$360.4m more than its cash and near-term receivables, combined.
Phibro Animal Health has a market capitalization of US$952.6m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). 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).
Phibro Animal Health's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 6.0 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly Phibro Animal Health's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Phibro Animal Health can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Phibro Animal Health's free cash flow amounted to 29% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Both Phibro Animal Health's conversion of EBIT to free cash flow and its net debt to EBITDA were discouraging. But its not so bad at covering its interest expense with its EBIT. We think that Phibro Animal Health's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 3 warning signs for Phibro Animal Health you should be aware of, and 1 of them is potentially serious.
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. 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.
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