Is Phibro Animal Health (NASDAQ:PAHC) A Risky Investment?

Warren Buffett famously said, '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 Phibro Animal Health Corporation (NASDAQ:PAHC) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Phibro Animal Health

How Much Debt Does Phibro Animal Health Carry?

As you can see below, at the end of March 2022, Phibro Animal Health had US$416.0m of debt, up from US$383.5m a year ago. Click the image for more detail. However, it does have US$96.3m in cash offsetting this, leading to net debt of about US$319.7m.

A Look At Phibro Animal Health's Liabilities

The latest balance sheet data shows that Phibro Animal Health had liabilities of US$187.1m due within a year, and liabilities of US$462.1m falling due after that. Offsetting these obligations, it had cash of US$96.3m as well as receivables valued at US$156.6m due within 12 months. So its liabilities total US$396.4m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Phibro Animal Health is worth US$697.5m, and thus could probably raise enough capital to shore up 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 6.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Phibro Animal Health grow its EBIT by 6.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Phibro Animal Health recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Phibro Animal Health's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at growing its EBIT. Taking the abovementioned factors together we do think Phibro Animal Health's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Phibro Animal Health is showing 3 warning signs in our investment analysis , and 2 of those are a bit concerning...

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.