We Think California Water Service Group (NYSE:CWT) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies California Water Service Group (NYSE:CWT) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for California Water Service Group

How Much Debt Does California Water Service Group Carry?

You can click the graphic below for the historical numbers, but it shows that California Water Service Group had US$1.09b of debt in December 2021, down from US$1.15b, one year before. However, it also had US$78.4m in cash, and so its net debt is US$1.01b.

How Strong Is California Water Service Group's Balance Sheet?

The latest balance sheet data shows that California Water Service Group had liabilities of US$256.6m due within a year, and liabilities of US$2.18b falling due after that. Offsetting these obligations, it had cash of US$78.4m as well as receivables valued at US$131.7m due within 12 months. So it has liabilities totalling US$2.23b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$3.00b, so it does suggest shareholders should keep an eye on California Water Service Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

California Water Service Group has a debt to EBITDA ratio of 4.0 and its EBIT covered its interest expense 3.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that California Water Service Group actually let its EBIT decrease by 2.7% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its 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 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 that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say California Water Service Group's conversion of EBIT to free cash flow was disappointing. But at least its EBIT growth rate is not so bad. It's also worth noting that California Water Service Group is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that California Water Service Group's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that California Water Service Group is showing 3 warning signs in our investment analysis , you should know about...

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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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.