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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that American Water Works Company, Inc. (NYSE:AWK) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for American Water Works Company

How Much Debt Does American Water Works Company Carry?

The chart below, which you can click on for greater detail, shows that American Water Works Company had US$12.4b in debt in December 2023; about the same as the year before. However, because it has a cash reserve of US$392.0m, its net debt is less, at about US$12.0b.

A Look At American Water Works Company's Liabilities

According to the last reported balance sheet, American Water Works Company had liabilities of US$2.15b due within 12 months, and liabilities of US$18.4b due beyond 12 months. Offsetting this, it had US$392.0m in cash and US$727.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$19.4b.

This deficit is considerable relative to its very significant market capitalization of US$22.7b, 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.

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.

American Water Works Company has a rather high debt to EBITDA ratio of 5.3 which suggests a meaningful debt load. However, its interest coverage of 4.0 is reasonably strong, which is a good sign. On a slightly more positive note, American Water Works Company grew its EBIT at 14% 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 ultimately the future profitability of the business will decide if American Water Works Company 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 clearly need to look at whether that EBIT is leading to corresponding 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 bigger picture, it seems clear to us that American Water Works Company's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that American Water Works Company is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.