Does Electro Optic Systems Holdings (ASX:EOS) Have A Healthy Balance Sheet?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Electro Optic Systems Holdings Limited (ASX:EOS) does carry debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Electro Optic Systems Holdings

What Is Electro Optic Systems Holdings's Net Debt?

As you can see below, Electro Optic Systems Holdings had AU$46.4m of debt at June 2024, down from AU$83.5m a year prior. However, its balance sheet shows it holds AU$52.2m in cash, so it actually has AU$5.87m net cash.

A Look At Electro Optic Systems Holdings' Liabilities

We can see from the most recent balance sheet that Electro Optic Systems Holdings had liabilities of AU$111.7m falling due within a year, and liabilities of AU$78.6m due beyond that. Offsetting these obligations, it had cash of AU$52.2m as well as receivables valued at AU$77.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$60.5m.

Of course, Electro Optic Systems Holdings has a market capitalization of AU$329.9m, 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. While it does have liabilities worth noting, Electro Optic Systems Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

We also note that Electro Optic Systems Holdings improved its EBIT from a last year's loss to a positive AU$18m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Electro Optic Systems Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Electro Optic Systems Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Electro Optic Systems Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While Electro Optic Systems Holdings does have more liabilities than liquid assets, it also has net cash of AU$5.87m. The cherry on top was that in converted 278% of that EBIT to free cash flow, bringing in AU$49m. So we don't have any problem with Electro Optic Systems Holdings's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Electro Optic Systems Holdings that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.