Is Earthworks Industries (CVE:EWK) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Earthworks Industries Inc. (CVE:EWK) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Earthworks Industries

What Is Earthworks Industries's Debt?

As you can see below, Earthworks Industries had CA$7.56m of debt at May 2021, down from CA$8.24m a year prior. On the flip side, it has CA$221.5k in cash leading to net debt of about CA$7.34m.

How Healthy Is Earthworks Industries' Balance Sheet?

According to the last reported balance sheet, Earthworks Industries had liabilities of CA$2.14m due within 12 months, and liabilities of CA$6.22m due beyond 12 months. Offsetting these obligations, it had cash of CA$221.5k as well as receivables valued at CA$20.0k due within 12 months. So it has liabilities totalling CA$8.12m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Earthworks Industries has a market capitalization of CA$18.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Earthworks Industries 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.

Given it has no significant operating revenue at the moment, shareholders will be hoping Earthworks Industries can make progress and gain better traction for the business, before it runs low on cash.

Caveat Emptor

Importantly, Earthworks Industries had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CA$485k. 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 CA$456k in negative free cash flow over the last twelve months. So to be blunt we think it is risky. 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. We've identified 4 warning signs with Earthworks Industries (at least 2 which are concerning) , and understanding them should be part of your investment process.

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.
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