Middlesex Water (NASDAQ:MSEX) Takes On Some Risk With Its Use Of Debt

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. We note that Middlesex Water Company (NASDAQ:MSEX) does have debt on its balance sheet. But is this debt a concern to shareholders?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

Check out our latest analysis for Middlesex Water

How Much Debt Does Middlesex Water Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Middlesex Water had US$391.4m of debt, an increase on US$340.7m, over one year. 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$87.6m due within 12 months, and liabilities of US$626.5m due beyond 12 months. On the other hand, it had cash of US$4.38m and US$26.3m worth of receivables due within a year. So its liabilities total US$683.4m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Middlesex Water is worth US$1.20b, and thus could probably raise enough capital to shore up 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

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 4.2 is reasonably strong, which is a good sign. On a lighter note, we note that Middlesex Water grew its EBIT by 21% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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

While Middlesex Water's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But at least its EBIT growth rate is a gleaming silver lining to those clouds. We should also note that Water Utilities industry companies like Middlesex Water commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Middlesex Water is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Middlesex Water (1 is concerning) 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.