We Think FOS Capital (ASX:FOS) Can Stay On Top Of Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that FOS Capital Limited (ASX:FOS) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

See our latest analysis for FOS Capital

How Much Debt Does FOS Capital Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 FOS Capital had AU$2.65m of debt, an increase on none, over one year. However, it also had AU$1.68m in cash, and so its net debt is AU$975.1k.

A Look At FOS Capital's Liabilities

The latest balance sheet data shows that FOS Capital had liabilities of AU$7.70m due within a year, and liabilities of AU$4.17m falling due after that. Offsetting this, it had AU$1.68m in cash and AU$4.94m in receivables that were due within 12 months. So it has liabilities totalling AU$5.25m more than its cash and near-term receivables, combined.

This deficit isn't so bad because FOS Capital is worth AU$16.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Looking at its net debt to EBITDA of 0.53 and interest cover of 5.8 times, it seems to us that FOS Capital is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, FOS Capital's EBIT launched higher than Elon Musk, gaining a whopping 161% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since FOS Capital will need earnings to service that debt. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, FOS Capital produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that FOS Capital's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Taking all this data into account, it seems to us that FOS Capital takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for FOS Capital you should be aware of.

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.