United Utilities Group (LON:UU.) Use Of Debt Could Be Considered Risky

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that United Utilities Group PLC (LON:UU.) does use debt in its business. But is this debt a concern to shareholders?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for United Utilities Group

What Is United Utilities Group's Debt?

As you can see below, at the end of March 2023, United Utilities Group had UK£8.44b of debt, up from UK£7.92b a year ago. Click the image for more detail. However, because it has a cash reserve of UK£340.4m, its net debt is less, at about UK£8.10b.

How Strong Is United Utilities Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that United Utilities Group had liabilities of UK£575.9m due within 12 months and liabilities of UK£11.4b due beyond that. Offsetting this, it had UK£340.4m in cash and UK£289.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£11.4b.

This deficit casts a shadow over the UK£6.85b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, United Utilities Group 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). 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).

Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 9.1 hit our confidence in United Utilities Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, United Utilities Group saw its EBIT tank 25% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 United Utilities Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, United Utilities Group's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, United Utilities Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. 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. 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 example, we've discovered 3 warning signs for United Utilities Group (1 can't be ignored!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.