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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that EuroDry Ltd. (NASDAQ:EDRY) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does EuroDry Carry?

As you can see below, at the end of September 2021, EuroDry had US$73.2m of debt, up from US$52.2m a year ago. Click the image for more detail. However, it also had US$17.0m in cash, and so its net debt is US$56.2m.

How Healthy Is EuroDry’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that EuroDry had liabilities of US$18.9m due within 12 months and liabilities of US$61.8m due beyond that. On the other hand, it had cash of US$17.0m and US$2.60m worth of receivables due within a year. So it has liabilities totalling US$61.1m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company’s market capitalization of US$60.7m, we think shareholders really should watch EuroDry’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

EuroDry’s net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 11.9 times, makes us even more comfortable. We also note that EuroDry improved its EBIT from a last year’s loss to a positive US$24m. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine EuroDry’s ability to maintain a healthy balance sheet going forward.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, EuroDry 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

We’d go so far as to say EuroDry’s conversion of EBIT to free cash flow was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that EuroDry has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt.