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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Middlesex Water Company (NASDAQ:MSEX) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Middlesex Water

What Is Middlesex Water's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Middlesex Water had debt of US$349.3m, up from US$323.3m in one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Middlesex Water's Balance Sheet?

According to the last reported balance sheet, Middlesex Water had liabilities of US$93.0m due within 12 months, and liabilities of US$571.5m due beyond 12 months. Offsetting these obligations, it had cash of US$2.91m as well as receivables valued at US$29.1m due within 12 months. So its liabilities total US$632.5m more than the combination of its cash and short-term receivables.

Middlesex Water has a market capitalization of US$1.51b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Middlesex Water has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 5.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We note that Middlesex Water grew its EBIT by 20% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Middlesex Water's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its EBIT growth rate was refreshing. We should also note that Water Utilities industry companies like Middlesex Water commonly do use debt without problems. Taking the abovementioned factors together we do think Middlesex Water's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 2 warning signs we've spotted with Middlesex Water (including 1 which can't be ignored) .

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.