Elanco Animal Health (NYSE:ELAN) Seems To Be Using A Lot Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Elanco Animal Health Incorporated (NYSE:ELAN) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. 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 Elanco Animal Health

What Is Elanco Animal Health's Debt?

As you can see below, Elanco Animal Health had US$5.91b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$369.0m in cash leading to net debt of about US$5.54b.

A Look At Elanco Animal Health's Liabilities

We can see from the most recent balance sheet that Elanco Animal Health had liabilities of US$1.27b falling due within a year, and liabilities of US$6.95b due beyond that. On the other hand, it had cash of US$369.0m and US$1.14b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.71b.

This is a mountain of leverage relative to its market capitalization of US$8.07b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Elanco Animal Health shareholders face the double whammy of a high net debt to EBITDA ratio (5.7), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. The debt burden here is substantial. Even worse, Elanco Animal Health saw its EBIT tank 26% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Elanco Animal Health's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Elanco Animal Health's free cash flow amounted to 30% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Elanco Animal Health's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. After considering the datapoints discussed, we think Elanco Animal Health has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For instance, we've identified 1 warning sign for Elanco Animal Health that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.