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.' 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. We note that Dechra Pharmaceuticals PLC (LON:DPH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Dechra Pharmaceuticals's Debt?
As you can see below, at the end of December 2018, Dechra Pharmaceuticals had UK£316.5m of debt, up from UK£174.5m a year ago. Click the image for more detail. However, because it has a cash reserve of UK£86.9m, its net debt is less, at about UK£229.6m.
How Healthy Is Dechra Pharmaceuticals's Balance Sheet?
According to the last reported balance sheet, Dechra Pharmaceuticals had liabilities of UK£104.3m due within 12 months, and liabilities of UK£437.8m due beyond 12 months. Offsetting these obligations, it had cash of UK£86.9m as well as receivables valued at UK£77.7m due within 12 months. So it has liabilities totalling UK£377.5m more than its cash and near-term receivables, combined.
Since publicly traded Dechra Pharmaceuticals shares are worth a total of UK£3.06b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Dechra Pharmaceuticals's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 3.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Dechra Pharmaceuticals's EBIT was down 27% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Dechra Pharmaceuticals 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 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, Dechra Pharmaceuticals actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Dechra Pharmaceuticals's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Dechra Pharmaceuticals's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you're interested in Dechra Pharmaceuticals, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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