These 4 Measures Indicate That Euroseas (NASDAQ:ESEA) Is Using Debt Reasonably Well

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 note that Euroseas Ltd. (NASDAQ:ESEA) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Euroseas

What Is Euroseas's Debt?

As you can see below, at the end of December 2021, Euroseas had US$118.0m of debt, up from US$69.9m a year ago. Click the image for more detail. However, it does have US$26.5m in cash offsetting this, leading to net debt of about US$91.5m.

How Strong Is Euroseas' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Euroseas had liabilities of US$37.1m due within 12 months and liabilities of US$107.6m due beyond that. Offsetting this, it had US$26.5m in cash and US$3.00m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$115.2m.

While this might seem like a lot, it is not so bad since Euroseas has a market capitalization of US$213.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Euroseas's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 16.4 times, makes us even more comfortable. Pleasingly, Euroseas is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 969% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Euroseas's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Euroseas burned a lot of cash. 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

Euroseas's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Euroseas's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 Euroseas (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.