Here's Why American Water Works Company (NYSE:AWK) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, American Water Works Company, Inc. (NYSE:AWK) does carry 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 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for American Water Works Company

What Is American Water Works Company's Net Debt?

The chart below, which you can click on for greater detail, shows that American Water Works Company had US$12.2b in debt in September 2023; about the same as the year before. However, it also had US$700.0m in cash, and so its net debt is US$11.5b.

How Healthy Is American Water Works Company's Balance Sheet?

The latest balance sheet data shows that American Water Works Company had liabilities of US$1.74b due within a year, and liabilities of US$18.2b falling due after that. On the other hand, it had cash of US$700.0m and US$754.5m worth of receivables due within a year. So it has liabilities totalling US$18.5b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of US$25.7b, so it does suggest shareholders should keep an eye on American Water Works Company's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

American Water Works Company has a rather high debt to EBITDA ratio of 5.2 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. On a slightly more positive note, American Water Works Company grew its EBIT at 15% over the last year, further increasing its ability to manage 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 American Water Works Company's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, American Water Works Company 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, American Water Works Company'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 it's pretty decent at growing its EBIT; that's encouraging. We should also note that Water Utilities industry companies like American Water Works Company commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making American Water Works Company stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for American Water Works Company you should be aware of, and 1 of them doesn't sit too well with us.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.