Severn Trent (LON:SVT) Use Of Debt Could Be Considered Risky

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.' 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. As with many other companies Severn Trent PLC (LON:SVT) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Severn Trent

How Much Debt Does Severn Trent Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Severn Trent had UK£8.70b of debt, an increase on UK£7.72b, over one year. However, because it has a cash reserve of UK£1.06b, its net debt is less, at about UK£7.64b.

How Healthy Is Severn Trent's Balance Sheet?

The latest balance sheet data shows that Severn Trent had liabilities of UK£817.7m due within a year, and liabilities of UK£12.3b falling due after that. Offsetting these obligations, it had cash of UK£1.06b as well as receivables valued at UK£852.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£11.2b.

This deficit casts a shadow over the UK£7.32b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Severn Trent would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Severn Trent has a rather high debt to EBITDA ratio of 8.1 which suggests a meaningful debt load. However, its interest coverage of 2.5 is reasonably strong, which is a good sign. The good news is that Severn Trent improved its EBIT by 9.4% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Severn Trent 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.

Our View

On the face of it, Severn Trent's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Severn Trent is in the Water Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Severn Trent that you should be aware of before investing here.

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.