Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Elanco Animal Health Incorporated (NYSE:ELAN) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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, 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Elanco Animal Health

What Is Elanco Animal Health's Debt?

The image below, which you can click on for greater detail, shows that at June 2019 Elanco Animal Health had debt of US$2.41b, up from none in one year. However, because it has a cash reserve of US$385.1m, its net debt is less, at about US$2.02b.

How Healthy Is Elanco Animal Health's Balance Sheet?

The latest balance sheet data shows that Elanco Animal Health had liabilities of US$777.5m due within a year, and liabilities of US$2.81b falling due after that. Offsetting this, it had US$385.1m in cash and US$831.5m in receivables that were due within 12 months. So it has liabilities totalling US$2.37b more than its cash and near-term receivables, combined.

Elanco Animal Health has a very large market capitalization of US$11.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Elanco Animal Health has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 6.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Elanco Animal Health's EBIT launched higher than Elon Musk, gaining a whopping 144% on last year. 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 Elanco Animal Health'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. Looking at the most recent three years, Elanco Animal Health recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Elanco Animal Health's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. All these things considered, it appears that Elanco Animal Health can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that Elanco Animal Health insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.