Elanco Animal Health (NYSE: ELAN) has a somewhat strained record

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Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We can see that Elanco Animal Health Incorporated (NYSE: ELAN) uses debt in its business. But does this debt concern shareholders?

When is debt dangerous?

Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.

What is Elanco Animal Health’s net debt?

You can click on the graph below for historical figures, but it shows that as of June 2021 Elanco Animal Health was in debt of $ 6.13 billion, an increase from $ 2.13 billion. US, over one year. However, it has US $ 580.0 million in cash offsetting this, which leads to net debt of around US $ 5.55 billion.

NYSE: ELAN Debt to Equity History October 21, 2021

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 $ 1.99 billion maturing within one year and liabilities of US $ 6.86 billion coming due. deadline beyond. In compensation for these obligations, it had cash of US $ 580.0 million as well as receivables valued at US $ 1.17 billion due within 12 months. It therefore has liabilities totaling US $ 7.10 billion more than its cash and short-term receivables combined.

Elanco Animal Health has a very large market cap of $ 15.9 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.

We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).

The low interest coverage of 1.1 times and an unusually high Net Debt / EBITDA ratio of 5.9 hit our confidence in Elanco Animal Health like a punch in the gut. This means that we would consider him to be in heavy debt. However, a buyout factor is that Elanco Animal Health has increased its EBIT to 12% over the past 12 months, increasing its ability to manage debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine Elanco Animal Health’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.

Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Elanco Animal Health has recorded total negative free cash flow. Debt is much riskier for companies with unreliable free cash flow, so shareholders should hope that past spending will produce free cash flow in the future.

Our point of view

To be frank, Elanco Animal Health’s net debt on EBITDA and its history of hedging its interest charges with its EBIT makes us rather uncomfortable with its debt levels. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. Looking at the big picture, it seems clear to us that Elanco Animal Health’s use of debt creates risks for the business. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. Given our hesitation on the stock, it would be nice to know if Elanco Animal Health insiders have sold any shares recently. You click here to see if any insiders have sold recently.

At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.

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