Here's Why Middlesex Water (NASDAQ:MSEX) Has A Meaningful Debt Burden

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.' 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. As with many other companies Middlesex Water Company (NASDAQ:MSEX) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Middlesex Water

What Is Middlesex Water's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2021 Middlesex Water had US$292.8m of debt, an increase on US$275.5m, over one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Middlesex Water's Balance Sheet?

We can see from the most recent balance sheet that Middlesex Water had liabilities of US$65.8m falling due within a year, and liabilities of US$569.5m due beyond that. Offsetting these obligations, it had cash of US$4.05m as well as receivables valued at US$19.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$611.3m.

Middlesex Water has a market capitalization of US$1.43b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Middlesex Water has a debt to EBITDA ratio of 4.9 and its EBIT covered its interest expense 4.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Middlesex Water grew its EBIT by 8.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Middlesex Water 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Middlesex Water burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Middlesex Water'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. It's also worth noting that Middlesex Water is in the Water Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Middlesex Water stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 Middlesex Water has 2 warning signs (and 1 which is a bit concerning) we think 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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