Does FOS Capital (ASX:FOS) Have A Healthy Balance Sheet?

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.' 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. We can see that FOS Capital Limited (ASX:FOS) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for FOS Capital

What Is FOS Capital's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 FOS Capital had debt of AU$2.83m, up from none in one year. However, it does have AU$1.23m in cash offsetting this, leading to net debt of about AU$1.60m.

How Healthy Is FOS Capital's Balance Sheet?

According to the last reported balance sheet, FOS Capital had liabilities of AU$7.54m due within 12 months, and liabilities of AU$1.94m due beyond 12 months. Offsetting this, it had AU$1.23m in cash and AU$4.70m in receivables that were due within 12 months. So its liabilities total AU$3.54m more than the combination of its cash and short-term receivables.

FOS Capital has a market capitalization of AU$11.3m, 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 1.6, FOS Capital uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. On top of that, FOS Capital grew its EBIT by 65% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is FOS Capital's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, FOS Capital burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

FOS Capital's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about FOS Capital's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more 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. Be aware that FOS Capital is showing 4 warning signs in our investment analysis , and 2 of those are concerning...

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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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.