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. We note that e.l.f. Beauty, Inc. (NYSE:ELF) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for e.l.f. Beauty

How Much Debt Does e.l.f. Beauty Carry?

As you can see below, e.l.f. Beauty had US$133.1m of debt at June 2020, down from US$142.6m a year prior. However, it also had US$54.2m in cash, and so its net debt is US$78.9m.

NYSE:ELF Debt to Equity History September 25th 2020

How Healthy Is e.l.f. Beauty’s Balance Sheet?

We can see from the most recent balance sheet that e.l.f. Beauty had liabilities of US$57.2m falling due within a year, and liabilities of US$156.1m due beyond that. On the other hand, it had cash of US$54.2m and US$29.8m worth of receivables due within a year. So its liabilities total US$129.3m more than the combination of its cash and short-term receivables.

Since publicly traded e.l.f. Beauty shares are worth a total of US$933.8m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

e.l.f. Beauty has net debt worth 2.0 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that e.l.f. Beauty’s EBIT was down 21% 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 ultimately the future profitability of the business will decide if e.l.f. Beauty 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, e.l.f. Beauty actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

e.l.f. Beauty’s EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There’s no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about e.l.f. Beauty’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Consider risks, for instance. Every company has them, and we’ve spotted 3 warning signs for e.l.f. Beauty you should know about.

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. 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.
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