David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 California Water Service Group (NYSE:CWT) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is California Water Service Group's Net Debt?
As you can see below, California Water Service Group had US$1.18b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$140.4m in cash leading to net debt of about US$1.04b.
How Healthy Is California Water Service Group's Balance Sheet?
The latest balance sheet data shows that California Water Service Group had liabilities of US$360.9m due within a year, and liabilities of US$2.20b falling due after that. On the other hand, it had cash of US$140.4m and US$157.6m worth of receivables due within a year. So its liabilities total US$2.26b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$3.29b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
California Water Service Group has a debt to EBITDA ratio of 4.0 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. Fortunately, California Water Service Group grew its EBIT by 8.7% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine California Water Service Group'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, California Water Service Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mulling over California Water Service Group's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like California Water Service Group commonly do use debt without problems. Overall, we think it's fair to say that California Water Service Group has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for California Water Service Group (1 is a bit unpleasant) you should be aware of.
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.
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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.