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.' 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. As with many other companies Watts Water Technologies, Inc. (NYSE:WTS) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Watts Water Technologies's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2022 Watts Water Technologies had debt of US$202.2m, up from US$192.3m in one year. But it also has US$231.9m in cash to offset that, meaning it has US$29.7m net cash.
A Look At Watts Water Technologies' Liabilities
We can see from the most recent balance sheet that Watts Water Technologies had liabilities of US$421.1m falling due within a year, and liabilities of US$326.7m due beyond that. On the other hand, it had cash of US$231.9m and US$267.1m worth of receivables due within a year. So its liabilities total US$248.8m more than the combination of its cash and short-term receivables.
Given Watts Water Technologies has a market capitalization of US$4.73b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Watts Water Technologies also has more cash than debt, so we're pretty confident it can manage its debt safely.
Another good sign is that Watts Water Technologies has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. 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 Watts Water Technologies 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Watts Water Technologies has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Watts Water Technologies recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
We could understand if investors are concerned about Watts Water Technologies's liabilities, but we can be reassured by the fact it has has net cash of US$29.7m. And it impressed us with its EBIT growth of 26% over the last year. So is Watts Water Technologies's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Watts Water Technologies is showing 1 warning sign in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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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