Euroseas (NASDAQ:ESEA) Has A Pretty Healthy Balance Sheet

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. We can see that Euroseas Ltd. (NASDAQ:ESEA) does use debt in its business. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Euroseas

What Is Euroseas's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Euroseas had debt of US$147.4m, up from US$120.1m in one year. However, it does have US$49.4m in cash offsetting this, leading to net debt of about US$98.0m.

How Strong Is Euroseas' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Euroseas had liabilities of US$67.0m due within 12 months and liabilities of US$116.2m due beyond that. On the other hand, it had cash of US$49.4m and US$5.67m worth of receivables due within a year. So its liabilities total US$128.2m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Euroseas has a market capitalization of US$268.3m, 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.

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.

Euroseas has a low net debt to EBITDA ratio of only 0.81. And its EBIT easily covers its interest expense, being 21.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Euroseas has increased its EBIT by 6.9% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Euroseas can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Euroseas recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

When it comes to the balance sheet, the standout positive for Euroseas was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Euroseas's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Euroseas (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com