Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies e.l.f. Beauty, Inc. (NYSE:ELF) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 e.l.f. Beauty’s Net Debt?
The image below, which you can click on for greater detail, shows that e.l.f. Beauty had debt of US$96.6m at the end of December 2021, a reduction from US$127.3m over a year. However, because it has a cash reserve of US$32.9m, its net debt is less, at about US$63.8m.
How Strong 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$62.5m falling due within a year, and liabilities of US$123.0m due beyond that. Offsetting this, it had US$32.9m in cash and US$47.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$105.4m.
Of course, e.l.f. Beauty has a market capitalization of US$1.37b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
e.l.f. Beauty’s net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 10.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, e.l.f. Beauty grew its EBIT by 131% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, e.l.f. Beauty recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Our View
The good news is that e.l.f. Beauty’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that e.l.f. Beauty is quite prudent with its debt, and the risks seem well managed. So we’re not worried about the use of a little leverage on the balance sheet.
