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.’ 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. We can see that Ebix, Inc. (NASDAQ:EBIX) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Ebix’s Net Debt?
As you can see below, Ebix had US$702.0m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$122.4m in cash, and so its net debt is US$579.6m.
A Look At Ebix’s Liabilities
According to the last reported balance sheet, Ebix had liabilities of US$177.9m due within 12 months, and liabilities of US$711.9m due beyond 12 months. On the other hand, it had cash of US$122.4m and US$160.5m worth of receivables due within a year. So its liabilities total US$606.9m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$948.6m, so it does suggest shareholders should keep an eye on Ebix’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Ebix has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. More concerning, Ebix saw its EBIT drop by 6.7% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Ebix 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Ebix recorded free cash flow of 46% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
To be frank both Ebix’s EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Ebix stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start.