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.’ 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. We can see that Evolus, Inc. (NASDAQ:EOLS) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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.
What Is Evolus’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Evolus had US$19.6m of debt in June 2021, down from US$74.2m, one year before. But it also has US$131.7m in cash to offset that, meaning it has US$112.1m net cash.
How Healthy Is Evolus’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Evolus had liabilities of US$87.3m due within 12 months and liabilities of US$46.4m due beyond that. Offsetting this, it had US$131.7m in cash and US$11.9m in receivables that were due within 12 months. So it can boast US$9.88m more liquid assets than total liabilities.
This surplus suggests that Evolus has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Evolus has more cash than debt is arguably a good indication that it can manage its debt safely. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Evolus’s ability to maintain a healthy balance sheet going forward.
Over 12 months, Evolus reported revenue of US$77m, which is a gain of 50%, although it did not report any earnings before interest and tax. Shareholders probably have their fingers crossed that it can grow its way to profits.
So How Risky Is Evolus?
We have no doubt that loss making companies are, in general, riskier than profitable ones. And we do note that Evolus had an earnings before interest and tax (EBIT) loss, over the last year. And over the same period it saw negative free cash outflow of US$9.8m and booked a US$131m accounting loss. With only US$112.1m on the balance sheet, it would appear that its going to need to raise capital again soon. Evolus’s revenue growth shone bright over the last year, so it may well be in a position to turn a profit in due course. By investing before those profits, shareholders take on more risk in the hope of bigger rewards. 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.