Does American States Water (NYSE:AWR) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 States Water Company (NYSE:AWR) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for American States Water

How Much Debt Does American States Water Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 American States Water had US$688.7m of debt, an increase on US$602.5m, over one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is American States Water's Balance Sheet?

The latest balance sheet data shows that American States Water had liabilities of US$373.2m due within a year, and liabilities of US$903.9m falling due after that. Offsetting these obligations, it had cash of US$2.26m as well as receivables valued at US$95.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.18b.

While this might seem like a lot, it is not so bad since American States Water has a market capitalization of US$3.62b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

American States Water has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 6.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, American States Water saw its EBIT slide 4.9% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 States Water'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.

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, American States Water recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Mulling over American States Water's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its interest cover is not so bad. It's also worth noting that American States Water is in the Water Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that American States Water's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For instance, we've identified 2 warning signs for American States Water (1 shouldn't be ignored) you should be aware of.

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.