Here's Why Elanco Animal Health (NYSE:ELAN) Is Weighed Down By Its Debt Load

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Elanco Animal Health Incorporated (NYSE:ELAN) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Elanco Animal Health

What Is Elanco Animal Health's Net Debt?

The chart below, which you can click on for greater detail, shows that Elanco Animal Health had US$6.03b in debt in March 2023; about the same as the year before. However, it does have US$326.0m in cash offsetting this, leading to net debt of about US$5.70b.

How Strong Is Elanco Animal Health's Balance Sheet?

We can see from the most recent balance sheet that Elanco Animal Health had liabilities of US$1.58b falling due within a year, and liabilities of US$6.71b due beyond that. On the other hand, it had cash of US$326.0m and US$1.26b worth of receivables due within a year. So it has liabilities totalling US$6.70b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$5.90b, we think shareholders really should watch Elanco Animal Health's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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).

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.4 hit our confidence in Elanco Animal Health like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even more troubling is the fact that Elanco Animal Health actually let its EBIT decrease by 5.6% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Elanco 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 created free cash flow amounting to 6.1% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

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. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Elanco Animal Health has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 2 warning signs for Elanco Animal Health that you should be aware of before investing here.

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.