Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Artesian Resources Corporation (NASDAQ:ARTN.A) does carry debt. But the real question is whether this debt is making the company risky.
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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Artesian Resources Carry?
As you can see below, at the end of March 2021, Artesian Resources had US$166.3m of debt, up from US$154.0m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Artesian Resources' Balance Sheet?
We can see from the most recent balance sheet that Artesian Resources had liabilities of US$44.2m falling due within a year, and liabilities of US$382.3m due beyond that. Offsetting this, it had US$249.0k in cash and US$9.97m in receivables that were due within 12 months. So it has liabilities totalling US$416.3m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$389.0m market capitalization, you might well be inclined to review the balance sheet intently. 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Artesian Resources's debt is 4.2 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Artesian Resources improved its EBIT by 9.8% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Artesian Resources's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Artesian Resources burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We'd go so far as to say Artesian Resources's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like Artesian Resources commonly do use debt without problems. Overall, it seems to us that Artesian Resources's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 1 warning sign for Artesian Resources that you should be aware of before investing here.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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What are the risks and opportunities for Artesian Resources?
Price-To-Earnings ratio (31.4x) is below the Water Utilities industry average (37.3x)
Earnings have grown 5.7% per year over the past 5 years
Debt is not well covered by operating cash flow
This article by Simply Wall St is general in nature. 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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