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. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, California Water Service Group (NYSE:CWT) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is California Water Service Group’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 California Water Service Group had debt of US$961.8m, up from US$894.2m in one year. However, it also had US$51.3m in cash, and so its net debt is US$910.6m.
How Strong Is California Water Service Group’s Balance Sheet?
According to the last reported balance sheet, California Water Service Group had liabilities of US$333.9m due within 12 months, and liabilities of US$1.93b due beyond 12 months. On the other hand, it had cash of US$51.3m and US$119.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.10b.
This is a mountain of leverage relative to its market capitalization of US$2.62b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
California Water Service Group’s debt is 4.5 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. More concerning, California Water Service Group saw its EBIT drop by 10.0% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine California Water Service Group’s ability to maintain a healthy balance sheet going forward. 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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, California Water Service Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over California Water Service Group’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. And furthermore, its EBIT growth rate also fails to instill confidence. It’s also worth noting that California Water Service Group is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that California Water Service Group’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Consider risks, for instance. Every company has them, and we’ve spotted 1 warning sign for California Water Service Group you should know about.
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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