Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. Importantly, e.l.f. Beauty, Inc. (NYSE:ELF) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does e.l.f. Beauty Carry?
As you can see below, e.l.f. Beauty had US$130.2m of debt at September 2020, down from US$140.3m a year prior. However, because it has a cash reserve of US$41.0m, its net debt is less, at about US$89.1m.
How Healthy Is e.l.f. Beauty’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that e.l.f. Beauty had liabilities of US$61.0m due within 12 months and liabilities of US$157.7m due beyond that. Offsetting this, it had US$41.0m in cash and US$33.8m in receivables that were due within 12 months. So its liabilities total US$143.9m more than the combination of its cash and short-term receivables.
Given e.l.f. Beauty has a market capitalization of US$1.18b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
e.l.f. Beauty has net debt worth 2.4 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 28% 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. When analysing debt levels, the balance sheet is the obvious place to start. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
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 debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 3 warning signs for e.l.f. Beauty that you should be aware of.
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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