These 4 Measures Indicate That Energy Services of America (NASDAQ:ESOA) Is Using Debt Extensively

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.' 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 Energy Services of America Corporation (NASDAQ:ESOA) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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.

See our latest analysis for Energy Services of America

How Much Debt Does Energy Services of America Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Energy Services of America had debt of US$45.8m, up from US$21.9m in one year. On the flip side, it has US$9.04m in cash leading to net debt of about US$36.8m.

How Healthy Is Energy Services of America's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Energy Services of America had liabilities of US$80.0m due within 12 months and liabilities of US$20.3m due beyond that. Offsetting this, it had US$9.04m in cash and US$67.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$23.4m.

Energy Services of America has a market capitalization of US$73.4m, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Energy Services of America's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Also relevant is that Energy Services of America has grown its EBIT by a very respectable 21% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Energy Services of America can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Energy Services of America created free cash flow amounting to 18% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Neither Energy Services of America's ability to cover its interest expense with its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Energy Services of America is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For instance, we've identified 2 warning signs for Energy Services of America (1 is significant) 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.