Is Chesapeake Utilities (NYSE:CPK) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Chesapeake Utilities Corporation (NYSE:CPK) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Chesapeake Utilities

What Is Chesapeake Utilities's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2024 Chesapeake Utilities had debt of US$1.48b, up from US$1.39b in one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Chesapeake Utilities' Balance Sheet?

We can see from the most recent balance sheet that Chesapeake Utilities had liabilities of US$419.4m falling due within a year, and liabilities of US$1.77b due beyond that. On the other hand, it had cash of US$7.90m and US$121.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.06b.

This deficit is considerable relative to its market capitalization of US$2.89b, so it does suggest shareholders should keep an eye on Chesapeake Utilities' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

Chesapeake Utilities has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 3.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Looking on the bright side, Chesapeake Utilities boosted its EBIT by a silky 44% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Chesapeake Utilities 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.

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. Over the last three years, Chesapeake Utilities 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

Chesapeake Utilities's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. It's also worth noting that Chesapeake Utilities is in the Gas Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Chesapeake Utilities's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 2 warning signs for Chesapeake Utilities (1 is a bit concerning!) that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.