These 4 Measures Indicate That Essential Utilities (NYSE:WTRG) Is Using Debt Extensively

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Essential Utilities, Inc. (NYSE:WTRG) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Essential Utilities

What Is Essential Utilities's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Essential Utilities had US$6.89b of debt, an increase on US$6.23b, over one year. And it doesn't have much cash, so its net debt is about the same.

A Look At Essential Utilities' Liabilities

The latest balance sheet data shows that Essential Utilities had liabilities of US$765.1m due within a year, and liabilities of US$9.72b falling due after that. Offsetting this, it had US$11.6m in cash and US$225.7m in receivables that were due within 12 months. So it has liabilities totalling US$10.2b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$9.92b market capitalization, you might well be inclined to review the balance sheet intently. 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 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).

Essential Utilities has a rather high debt to EBITDA ratio of 6.8 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.5 times, suggesting it can responsibly service its obligations. Fortunately, Essential Utilities grew its EBIT by 9.7% in the last year, slowly shrinking its debt relative to earnings. 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 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Essential Utilities 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 Essential Utilities's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Essential Utilities is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

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.