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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies American States Water Company (NYSE:AWR) makes use of debt. But the real question is whether this debt is making the company risky.
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. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does American States Water Carry?
The image below, which you can click on for greater detail, shows that at March 2021 American States Water had debt of US$569.7m, up from US$513.3m in one year. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is American States Water's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that American States Water had liabilities of US$113.0m due within 12 months and liabilities of US$1.03b due beyond that. Offsetting this, it had US$6.95m in cash and US$81.3m in receivables that were due within 12 months. So its liabilities total US$1.06b more than the combination of its cash and short-term receivables.
American States Water has a market capitalization of US$2.94b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 6.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. American States Water grew its EBIT by 3.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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 States Water 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 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 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.
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. For example, its interest cover 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for American States Water you should be aware of.
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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American States Water
American States Water Company, through its subsidiaries, provides water and electric services to residential, commercial, industrial, and other customers in the United States.
Average dividend payer with questionable track record.