Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies California Water Service Group (NYSE:CWT) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does California Water Service Group Carry?
As you can see below, at the end of June 2019, California Water Service Group had US$971.9m of debt, up from US$844.7m a year ago. Click the image for more detail. However, it also had US$54.6m in cash, and so its net debt is US$917.3m.
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$331.4m due within a year, and liabilities of US$1.91b falling due after that. Offsetting these obligations, it had cash of US$54.6m as well as receivables valued at US$110.5m due within 12 months. So its liabilities total US$2.08b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$2.71b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
California Water Service Group has a debt to EBITDA ratio of 4.6 and its EBIT covered its interest expense 2.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Another concern for investors might be that California Water Service Group's EBIT fell 15% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 California Water Service 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by 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.
We'd go so far as to say California Water Service Group's conversion of EBIT to free cash flow was disappointing. And even its net debt to EBITDA fails to inspire much confidence. We should also note that Water Utilities industry companies like California Water Service Group commonly do use debt without problems. Overall, it seems to us that California Water Service Group's balance sheet is really quite a risk to the business. 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. Given our concerns about California Water Service Group's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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