Here's Why American States Water (NYSE:AWR) Has A Meaningful Debt Burden

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. Importantly, American States Water Company (NYSE:AWR) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 States Water

How Much Debt Does American States Water Carry?

As you can see below, at the end of June 2021, American States Water had US$600.7m of debt, up from US$530.2m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is American States Water's Balance Sheet?

We can see from the most recent balance sheet that American States Water had liabilities of US$111.4m falling due within a year, and liabilities of US$1.07b due beyond that. Offsetting these obligations, it had cash of US$5.36m as well as receivables valued at US$96.6m due within 12 months. So its liabilities total US$1.08b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since American States Water has a market capitalization of US$3.16b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

American States Water has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. American States Water grew its EBIT by 7.5% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 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 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, American States Water 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

American States Water's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its EBIT growth rate is relatively strong. We should also note that Water Utilities industry companies like American States Water commonly do use debt without problems. When we consider all the factors discussed, it seems to us that American States Water is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 2 warning signs for American States Water you should be aware of, and 1 of them is significant.

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.

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.

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