Stock Analysis

Is American States Water (NYSE:AWR) Using Too Much Debt?

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NYSE:AWR
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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?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does American States Water Carry?

The image below, which you can click on for greater detail, shows that at September 2021 American States Water had debt of US$602.5m, up from US$532.7m in one year. And it doesn't have much cash, so its net debt is about the same.

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NYSE:AWR Debt to Equity History January 10th 2022

How Healthy Is American States Water's Balance Sheet?

The latest balance sheet data shows that American States Water had liabilities of US$151.1m due within a year, and liabilities of US$1.04b falling due after that. Offsetting this, it had US$7.14m in cash and US$98.3m in receivables that were due within 12 months. So it has liabilities totalling US$1.09b more than its cash and near-term receivables, combined.

American States Water has a market capitalization of US$3.64b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

American States Water has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.8 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If American States Water can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if American States Water can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding 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

American States Water's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. It's also worth noting that American States Water is in the Water Utilities industry, which is often considered to be quite defensive. We think that American States Water's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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