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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies e.l.f. Beauty, Inc. (NYSE:ELF) makes use of debt. But should shareholders be worried about its use of debt?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is e.l.f. Beauty's Debt?
As you can see below, e.l.f. Beauty had US$142.6m of debt at June 2019, down from US$152.4m a year prior. However, it does have US$60.7m in cash offsetting this, leading to net debt of about US$81.9m.
A Look At e.l.f. Beauty's Liabilities
Zooming in on the latest balance sheet data, we can see that e.l.f. Beauty had liabilities of US$46.0m due within 12 months and liabilities of US$168.0m due beyond that. Offsetting these obligations, it had cash of US$60.7m as well as receivables valued at US$22.6m due within 12 months. So its liabilities total US$130.6m more than the combination of its cash and short-term receivables.
Of course, e.l.f. Beauty has a market capitalization of US$819.3m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Even though e.l.f. Beauty's debt is only 2.1, its interest cover is really very low at 2.1. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Shareholders should be aware that e.l.f. Beauty's EBIT was down 53% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine e.l.f. Beauty'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, e.l.f. Beauty's free cash flow amounted to 34% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
On the face of it, e.l.f. Beauty'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. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that e.l.f. Beauty's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if e.l.f. Beauty insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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