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.' 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. We note that Artesian Resources Corporation (NASDAQ:ARTN.A) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Artesian Resources Carry?
As you can see below, at the end of September 2020, Artesian Resources had US$168.2m of debt, up from US$148.0m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.
A Look At Artesian Resources's Liabilities
The latest balance sheet data shows that Artesian Resources had liabilities of US$43.6m due within a year, and liabilities of US$378.0m falling due after that. On the other hand, it had cash of US$249.0k and US$11.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$410.2m.
Given this deficit is actually higher than the company's market capitalization of US$356.0m, we think shareholders really should watch Artesian Resources'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.
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).
Artesian Resources's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, one redeeming factor is that Artesian Resources grew its EBIT at 16% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Artesian Resources will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Artesian Resources saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
We'd go so far as to say Artesian Resources's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Water Utilities industry companies like Artesian Resources commonly do use debt without problems. Overall, we think it's fair to say that Artesian Resources has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Be aware that Artesian Resources is showing 1 warning sign in our investment analysis , you should know about...
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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