Would Ecofibre (ASX:EOF) Be Better Off With Less 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Ecofibre Limited (ASX:EOF) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Ecofibre

How Much Debt Does Ecofibre Carry?

As you can see below, Ecofibre had AU$10.1m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of AU$5.92m, its net debt is less, at about AU$4.14m.

How Healthy Is Ecofibre's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ecofibre had liabilities of AU$7.09m due within 12 months and liabilities of AU$21.7m due beyond that. Offsetting these obligations, it had cash of AU$5.92m as well as receivables valued at AU$7.23m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$15.7m.

Given Ecofibre has a market capitalization of AU$145.7m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Ecofibre 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.

Over 12 months, Ecofibre made a loss at the EBIT level, and saw its revenue drop to AU$30m, which is a fall of 19%. That's not what we would hope to see.

Caveat Emptor

While Ecofibre's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable AU$17m 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$11m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very 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 2 warning signs for Ecofibre 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.