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 e.l.f. Beauty, Inc. (NYSE:ELF) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is e.l.f. Beauty’s Debt?
The image below, which you can click on for greater detail, shows that e.l.f. Beauty had debt of US$111.3m at the end of September 2021, a reduction from US$130.2m over a year. On the flip side, it has US$41.7m in cash leading to net debt of about US$69.6m.
A Look At e.l.f. Beauty’s Liabilities
We can see from the most recent balance sheet that e.l.f. Beauty had liabilities of US$71.2m falling due within a year, and liabilities of US$127.7m due beyond that. Offsetting this, it had US$41.7m in cash and US$44.4m in receivables that were due within 12 months. So its liabilities total US$112.9m more than the combination of its cash and short-term receivables.
Since publicly traded e.l.f. Beauty shares are worth a total of US$1.67b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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 has net debt of just 1.5 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.4 times the interest expense over the last year. In addition to that, we’re happy to report that e.l.f. Beauty has boosted its EBIT by 36%, thus reducing the spectre of future debt repayments. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, e.l.f. Beauty actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Happily, e.l.f. Beauty’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don’t think e.l.f. Beauty is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. When analysing debt levels, the balance sheet is the obvious place to start.