Does Severn Trent (LON:SVT) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Severn Trent Plc (LON:SVT) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Severn Trent

What Is Severn Trent's Debt?

As you can see below, at the end of March 2021, Severn Trent had UK£6.59b of debt, up from UK£6.31b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Severn Trent's Balance Sheet?

According to the last reported balance sheet, Severn Trent had liabilities of UK£1.08b due within 12 months, and liabilities of UK£8.81b due beyond 12 months. On the other hand, it had cash of UK£56.2m and UK£500.3m worth of receivables due within a year. So it has liabilities totalling UK£9.33b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's UK£6.95b market capitalization, you might well be inclined to review the balance sheet intently. 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).

Severn Trent has a rather high debt to EBITDA ratio of 8.1 which suggests a meaningful debt load. However, its interest coverage of 2.6 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that Severn Trent saw its EBIT drop by 16% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Severn Trent'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. Looking at the most recent three years, Severn Trent recorded free cash flow of 20% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Severn Trent's EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. It's also worth noting that Severn Trent is in the Water Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Severn Trent has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Severn Trent (1 is a bit concerning) you should be aware of.

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.

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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.
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