Is Middlesex Water (NASDAQ:MSEX) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Middlesex Water

What Is Middlesex Water's Debt?

As you can see below, at the end of December 2021, Middlesex Water had US$326.3m of debt, up from US$282.5m 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 Middlesex Water's Liabilities

According to the last reported balance sheet, Middlesex Water had liabilities of US$56.6m due within 12 months, and liabilities of US$593.6m due beyond 12 months. On the other hand, it had cash of US$3.53m and US$22.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$624.1m.

This deficit isn't so bad because Middlesex Water is worth US$1.75b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.2, it's fair to say Middlesex Water does have a significant amount of debt. However, its interest coverage of 4.3 is reasonably strong, which is a good sign. Even more troubling is the fact that Middlesex Water actually let its EBIT decrease by 6.5% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Middlesex Water'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Middlesex Water 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.

Our View

On the face of it, Middlesex Water's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. It's also worth noting that Middlesex Water is in the Water Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Middlesex Water 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. 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. For example - Middlesex Water has 1 warning sign we think you should be aware of.

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.