Here's Why Otter Tail (NASDAQ:OTTR) Can Manage Its Debt Responsibly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Otter Tail Corporation (NASDAQ:OTTR) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Otter Tail

What Is Otter Tail's Net Debt?

As you can see below, Otter Tail had US$861.8m of debt at March 2022, down from US$899.3m a year prior. Net debt is about the same, since the it doesn't have much cash.

A Look At Otter Tail's Liabilities

The latest balance sheet data shows that Otter Tail had liabilities of US$373.2m due within a year, and liabilities of US$1.37b falling due after that. Offsetting these obligations, it had cash of US$1.37m as well as receivables valued at US$218.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.52b.

This deficit isn't so bad because Otter Tail is worth US$2.82b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 2.2, Otter Tail uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.1 times its interest expenses harmonizes with that theme. Notably, Otter Tail's EBIT launched higher than Elon Musk, gaining a whopping 102% on last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Otter Tail 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Otter Tail recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

When it comes to the balance sheet, the standout positive for Otter Tail was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. We would also note that Electric Utilities industry companies like Otter Tail commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Otter Tail's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 2 warning signs with Otter Tail (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.