Essential Utilities (NYSE:WTRG) Use Of Debt Could Be Considered Risky

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 Essential Utilities, Inc. (NYSE:WTRG) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Essential Utilities

What Is Essential Utilities's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Essential Utilities had debt of US$7.02b, up from US$6.73b in one year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Essential Utilities' Balance Sheet?

The latest balance sheet data shows that Essential Utilities had liabilities of US$678.6m due within a year, and liabilities of US$10.3b falling due after that. Offsetting these obligations, it had cash of US$35.2m as well as receivables valued at US$267.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$10.7b.

Given this deficit is actually higher than the company's massive market capitalization of US$10.2b, we think shareholders really should watch Essential Utilities'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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Essential Utilities shareholders face the double whammy of a high net debt to EBITDA ratio (6.7), and fairly weak interest coverage, since EBIT is just 2.5 times the interest expense. This means we'd consider it to have a heavy debt load. Fortunately, Essential Utilities grew its EBIT by 5.6% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Essential Utilities can strengthen its balance sheet over time. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Essential Utilities burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Essential Utilities's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We should also note that Water Utilities industry companies like Essential Utilities commonly do use debt without problems. We're quite clear that we consider Essential Utilities to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 4 warning signs for Essential Utilities (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.

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