Here's Why Zurn Elkay Water Solutions (NYSE:ZWS) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Zurn Elkay Water Solutions Corporation (NYSE:ZWS) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Zurn Elkay Water Solutions

What Is Zurn Elkay Water Solutions's Debt?

The chart below, which you can click on for greater detail, shows that Zurn Elkay Water Solutions had US$534.3m in debt in March 2023; about the same as the year before. However, because it has a cash reserve of US$74.8m, its net debt is less, at about US$459.5m.

How Healthy Is Zurn Elkay Water Solutions' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zurn Elkay Water Solutions had liabilities of US$229.6m due within 12 months and liabilities of US$980.9m due beyond that. On the other hand, it had cash of US$74.8m and US$233.2m worth of receivables due within a year. So it has liabilities totalling US$902.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Zurn Elkay Water Solutions is worth US$4.47b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zurn Elkay Water Solutions's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 5.0 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. If Zurn Elkay Water Solutions can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Zurn Elkay Water Solutions 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zurn Elkay Water Solutions actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Zurn Elkay Water Solutions's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Taking all this data into account, it seems to us that Zurn Elkay Water Solutions takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Zurn Elkay Water Solutions is showing 3 warning signs 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.