The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘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. As with many other companies Middlesex Water Company (NASDAQ:MSEX) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Middlesex Water’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Middlesex Water had US$311.2m of debt, an increase on US$282.8m, over one year. And it doesn’t have much cash, so its net debt is about the same.
How Strong Is Middlesex Water’s Balance Sheet?
We can see from the most recent balance sheet that Middlesex Water had liabilities of US$80.7m falling due within a year, and liabilities of US$577.0m due beyond that. Offsetting these obligations, it had cash of US$6.03m as well as receivables valued at US$22.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$629.7m.
While this might seem like a lot, it is not so bad since Middlesex Water has a market capitalization of US$1.87b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Middlesex Water has a debt to EBITDA ratio of 5.0 and its EBIT covered its interest expense 5.0 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Middlesex Water grew its EBIT by 8.8% in the last year. That’s far from incredible but it is a good thing, when it comes to paying off debt. 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 Middlesex Water 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Middlesex Water 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.
Middlesex Water’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its EBIT growth rate is relatively strong. It’s also worth noting that Middlesex Water is in the Water Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Middlesex Water’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now.