Is United Utilities Group (LON:UU.) A Risky Investment?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that United Utilities Group PLC (LON:UU.) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for United Utilities Group

What Is United Utilities Group's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 United Utilities Group had debt of UK£9.09b, up from UK£8.20b in one year. However, because it has a cash reserve of UK£828.8m, its net debt is less, at about UK£8.26b.

A Look At United Utilities Group's Liabilities

The latest balance sheet data shows that United Utilities Group had liabilities of UK£689.5m due within a year, and liabilities of UK£12.2b falling due after that. Offsetting this, it had UK£828.8m in cash and UK£366.6m in receivables that were due within 12 months. So its liabilities total UK£11.6b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the UK£7.40b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, United Utilities Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.8 times and a disturbingly high net debt to EBITDA ratio of 9.6 hit our confidence in United Utilities Group like a one-two punch to the gut. The debt burden here is substantial. Worse, United Utilities Group's EBIT was down 21% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 United Utilities Group'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, United Utilities Group recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, United Utilities Group's net debt to EBITDA 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. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. We should also note that Water Utilities industry companies like United Utilities Group commonly do use debt without problems. After considering the datapoints discussed, we think United Utilities Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with United Utilities Group , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.