Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. It is natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. Mostly, Euroseas Ltd. (NASDAQ: ESEA) is in debt. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we think of a business’s use of debt, we first look at cash flow and debt together.
Discover our latest analysis for Euroseas
What is Euroseas’ debt?
The image below, which you can click for more details, shows Euroseas had a debt of US $ 65.0 million at the end of March 2021, a reduction from US $ 86.3 million over a year. However, it has $ 3.63 million in cash offsetting that, which leads to net debt of around $ 61.3 million.
How strong is Euroseas’ balance sheet?
The latest balance sheet data shows Euroseas had debts of $ 27.9 million maturing within one year, and debts of $ 43.6 million maturing after that. In compensation for these obligations, it had cash of US $ 3.63 million as well as receivables valued at US $ 3.49 million at 12 months. Its liabilities therefore total $ 64.4 million more than the combination of its cash and short-term receivables.
Euroseas has a market cap of $ 157.1 million, so it could very likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
The low interest coverage of 1.5 times and an unusually high net debt to EBITDA ratio of 5.7 affected our confidence in Euroseas like a punch in the stomach. This means that we would consider him to be in heavy debt. On a slightly more positive note, Euroseas increased its EBIT to 13% over the past year, further increasing its capacity to manage debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Euroseas can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Euroseas has burned a lot of money. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
At first glance, Euroseas’ interest hedging left us hesitant about the stock, and its conversion from EBIT to free cash flow was no more appealing than the single empty restaurant on the busiest night of the year. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. From a broader perspective, it seems clear to us that the use of debt by Euroseas creates risks for the company. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 5 warning signs for Euroseas (1 of which should not be ignored!) that you should know.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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