We Think Severn Trent (LON:SVT) Is Taking Some Risk With Its Debt

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 note that Severn Trent Plc (LON:SVT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for Severn Trent

What Is Severn Trent's Net Debt?

As you can see below, Severn Trent had UK£6.65b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.

A Look At Severn Trent's Liabilities

The latest balance sheet data shows that Severn Trent had liabilities of UK£1.06b due within a year, and liabilities of UK£9.23b falling due after that. On the other hand, it had cash of UK£115.4m and UK£594.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£9.58b.

Given this deficit is actually higher than the company's market capitalization of UK£6.45b, we think shareholders really should watch Severn Trent's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Severn Trent shareholders face the double whammy of a high net debt to EBITDA ratio (7.6), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. This means we'd consider it to have a heavy debt load. Fortunately, Severn Trent grew its EBIT by 6.6% in the last year, slowly shrinking its debt relative to 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Severn Trent recorded free cash flow of 35% 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 level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. 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. Overall, it seems to us that Severn Trent's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 2 warning signs for Severn Trent that you should be aware of before investing here.

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.