These 4 Measures Indicate That SJW Group (NYSE:SJW) Is Using Debt In A Risky Way

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 SJW Group (NYSE:SJW) makes use of debt. But is this debt a concern to shareholders?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that SJW is potentially overvalued!

What Is SJW Group's Net Debt?

As you can see below, at the end of June 2022, SJW Group had US$1.64b of debt, up from US$1.54b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Strong Is SJW Group's Balance Sheet?

According to the last reported balance sheet, SJW Group had liabilities of US$277.8m due within 12 months, and liabilities of US$2.23b due beyond 12 months. Offsetting these obligations, it had cash of US$12.0m as well as receivables valued at US$110.7m due within 12 months. So it has liabilities totalling US$2.39b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$1.98b, we think shareholders really should watch SJW Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

SJW Group shareholders face the double whammy of a high net debt to EBITDA ratio (8.0), and fairly weak interest coverage, since EBIT is just 1.8 times the interest expense. The debt burden here is substantial. Another concern for investors might be that SJW Group's EBIT fell 11% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine SJW Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, SJW 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.

Our View

To be frank both SJW Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its level of total liabilities also fails to instill confidence. It's also worth noting that SJW Group is in the Water Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think SJW Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 4 warning signs for SJW Group (1 is significant!) that you should be aware of before investing here.

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.