Here's Why Elanco Animal Health (NYSE:ELAN) Has A Meaningful Debt Burden

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. We can see that Elanco Animal Health Incorporated (NYSE:ELAN) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Elanco Animal Health

What Is Elanco Animal Health's Net Debt?

The image below, which you can click on for greater detail, shows that Elanco Animal Health had debt of US$5.68b at the end of June 2024, a reduction from US$6.06b over a year. On the flip side, it has US$416.0m in cash leading to net debt of about US$5.26b.

How Strong Is Elanco Animal Health's Balance Sheet?

The latest balance sheet data shows that Elanco Animal Health had liabilities of US$1.37b due within a year, and liabilities of US$6.45b falling due after that. Offsetting this, it had US$416.0m in cash and US$1.08b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.33b.

This is a mountain of leverage relative to its market capitalization of US$6.96b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

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 1.1 times the interest expense. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Elanco Animal Health saw its EBIT drop by 14% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Elanco 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Elanco Animal Health produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Elanco Animal Health's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Elanco Animal Health to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.