Chesapeake Utilities (NYSE:CPK) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Chesapeake Utilities Corporation (NYSE:CPK) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the US Gas Utilities industry.

What Is Chesapeake Utilities's Debt?

As you can see below, at the end of June 2022, Chesapeake Utilities had US$744.3m of debt, up from US$681.4m 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 Chesapeake Utilities' Balance Sheet?

The latest balance sheet data shows that Chesapeake Utilities had liabilities of US$287.3m due within a year, and liabilities of US$1.01b falling due after that. Offsetting this, it had US$4.19m in cash and US$68.5m in receivables that were due within 12 months. So it has liabilities totalling US$1.23b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Chesapeake Utilities has a market capitalization of US$2.19b, 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.

Chesapeake Utilities has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 6.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Chesapeake Utilities grew its EBIT by 7.9% 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 Chesapeake Utilities's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Chesapeake Utilities actually recorded a cash outflow, overall. 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

Chesapeake Utilities'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. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. We should also note that Gas Utilities industry companies like Chesapeake Utilities commonly do use debt without problems. Taking the abovementioned factors together we do think Chesapeake Utilities's debt poses some risks to the business. 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. To that end, you should learn about the 2 warning signs we've spotted with Chesapeake Utilities (including 1 which is concerning) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.