Is Evoqua Water Technologies (NYSE:AQUA) Using Too Much Debt?

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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 Evoqua Water Technologies Corp. (NYSE:AQUA) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Evoqua Water Technologies

What Is Evoqua Water Technologies's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2019 Evoqua Water Technologies had US$979.9m of debt, an increase on US$818.2m, over one year. However, because it has a cash reserve of US$66.9m, its net debt is less, at about US$913.1m.

How Healthy Is Evoqua Water Technologies's Balance Sheet?

According to the last reported balance sheet, Evoqua Water Technologies had liabilities of US$280.8m due within 12 months, and liabilities of US$1.02b due beyond 12 months. Offsetting these obligations, it had cash of US$66.9m as well as receivables valued at US$304.0m due within 12 months. So it has liabilities totalling US$933.9m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Evoqua Water Technologies is worth US$1.56b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Either way, since Evoqua Water Technologies does have more debt than cash, it's worth keeping an eye on its balance sheet.

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.

Evoqua Water Technologies shareholders face the double whammy of a high net debt to EBITDA ratio (5.40), and fairly weak interest coverage, since EBIT is just 1.31 times the interest expense. The debt burden here is substantial. Even worse, Evoqua Water Technologies saw its EBIT tank 44% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Evoqua Water Technologies can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Evoqua Water Technologies 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

On the face of it, Evoqua Water Technologies's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. After considering the datapoints discussed, we think Evoqua Water Technologies has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about Evoqua Water Technologies's debt levels, it seems only prudent to check if insiders have been ditching the stock.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.