Here's Why Electro Optic Systems Holdings (ASX:EOS) Can Afford Some Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Electro Optic Systems Holdings Limited (ASX:EOS) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

View our latest analysis for Electro Optic Systems Holdings

What Is Electro Optic Systems Holdings's Debt?

As you can see below, at the end of June 2023, Electro Optic Systems Holdings had AU$83.5m of debt, up from AU$34.8m a year ago. Click the image for more detail. However, it also had AU$42.0m in cash, and so its net debt is AU$41.5m.

A Look At Electro Optic Systems Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Electro Optic Systems Holdings had liabilities of AU$121.4m due within 12 months and liabilities of AU$76.0m due beyond that. On the other hand, it had cash of AU$42.0m and AU$105.3m worth of receivables due within a year. So its liabilities total AU$50.1m more than the combination of its cash and short-term receivables.

Electro Optic Systems Holdings has a market capitalization of AU$184.9m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

In the last year Electro Optic Systems Holdings had a loss before interest and tax, and actually shrunk its revenue by 5.9%, to AU$158m. We would much prefer see growth.

Caveat Emptor

Importantly, Electro Optic Systems Holdings had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable AU$47m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled AU$8.3m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Electro Optic Systems Holdings that 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.