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.' 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. Importantly, Ecovyst Inc. (NYSE:ECVT) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Ecovyst's Debt?

As you can see below, Ecovyst had US$862.8m of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$95.6m in cash offsetting this, leading to net debt of about US$767.2m.

How Strong Is Ecovyst's Balance Sheet?

We can see from the most recent balance sheet that Ecovyst had liabilities of US$97.0m falling due within a year, and liabilities of US$1.01b due beyond that. Offsetting these obligations, it had cash of US$95.6m as well as receivables valued at US$90.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$916.8m.

Given this deficit is actually higher than the company's market capitalization of US$817.6m, we think shareholders really should watch Ecovyst's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

While we wouldn't worry about Ecovyst's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 2.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that Ecovyst saw its EBIT drop by 14% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 Ecovyst 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ecovyst generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Ecovyst's EBIT growth rate and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Ecovyst's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Ecovyst you should be aware of.

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.