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. As with many other companies Eli Lilly and Company (NYSE:LLY) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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.

Check out our latest analysis for Eli Lilly

What Is Eli Lilly's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Eli Lilly had US$31.2b of debt, an increase on US$20.3b, over one year. However, because it has a cash reserve of US$3.52b, its net debt is less, at about US$27.7b.

How Strong Is Eli Lilly's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Eli Lilly had liabilities of US$24.7b due within 12 months and liabilities of US$36.6b due beyond that. Offsetting these obligations, it had cash of US$3.52b as well as receivables valued at US$12.0b due within 12 months. So its liabilities total US$45.7b more than the combination of its cash and short-term receivables.

Of course, Eli Lilly has a titanic market capitalization of US$741.3b, so these liabilities are probably manageable. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Eli Lilly's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its commanding EBIT of 28.7 times its interest expense, implies the debt load is as light as a peacock feather. In addition to that, we're happy to report that Eli Lilly has boosted its EBIT by 52%, 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 Eli Lilly 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Eli Lilly reported free cash flow worth 15% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Happily, Eli Lilly's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Eli Lilly is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. For example - Eli Lilly has 2 warning signs we think you should be aware of.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.