David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. Importantly, Eli Lilly and Company (NYSE:LLY) does carry debt. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for Eli Lilly
How Much Debt Does Eli Lilly Carry?
The image below, which you can click on for greater detail, shows that Eli Lilly had debt of US$15.6b at the end of March 2021, a reduction from US$17.6b over a year. However, it also had US$3.06b in cash, and so its net debt is US$12.6b.
A Look At Eli Lilly’s Liabilities
According to the last reported balance sheet, Eli Lilly had liabilities of US$11.7b due within 12 months, and liabilities of US$28.0b due beyond 12 months. Offsetting these obligations, it had cash of US$3.06b as well as receivables valued at US$6.63b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$30.0b.
Since publicly traded Eli Lilly shares are worth a very impressive total of US$182.7b, 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Eli Lilly has a low net debt to EBITDA ratio of only 1.5. And its EBIT covers its interest expense a whopping 21.4 times over. So we’re pretty relaxed about its super-conservative use of debt. Fortunately, Eli Lilly grew its EBIT by 9.4% in the last year, making that debt load look even more manageable. 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 Eli Lilly 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Eli Lilly produced sturdy free cash flow equating to 59% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Eli Lilly’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its conversion of EBIT to free cash flow is good too. When we consider the range of factors above, it looks like Eli Lilly is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Eli Lilly is showing 2 warning signs in our investment analysis , you should know about…
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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