Is Etherstack (ASX:ESK) Using Too Much 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 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. As with many other companies Etherstack plc (ASX:ESK) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Etherstack

How Much Debt Does Etherstack Carry?

You can click the graphic below for the historical numbers, but it shows that Etherstack had US$2.43m of debt in June 2024, down from US$2.74m, one year before. However, it does have US$1.36m in cash offsetting this, leading to net debt of about US$1.08m.

A Look At Etherstack's Liabilities

We can see from the most recent balance sheet that Etherstack had liabilities of US$3.40m falling due within a year, and liabilities of US$2.88m due beyond that. On the other hand, it had cash of US$1.36m and US$3.47m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.46m.

Given Etherstack has a market capitalization of US$19.5m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Even though Etherstack's debt is only 1.8, its interest cover is really very low at 1.7. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Notably, Etherstack made a loss at the EBIT level, last year, but improved that to positive EBIT of US$360k in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Etherstack will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Etherstack saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Both Etherstack's conversion of EBIT to free cash flow and its interest cover were discouraging. At least its level of total liabilities gives us reason to be optimistic. Taking the abovementioned factors together we do think Etherstack's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Etherstack .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.