Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Watts Water Technologies, Inc. (NYSE:WTS) does carry debt. But the more important question is: how much risk is that debt creating?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Watts Water Technologies Carry?
You can click the graphic below for the historical numbers, but it shows that Watts Water Technologies had US$343.8m of debt in June 2019, down from US$409.2m, one year before. On the flip side, it has US$166.8m in cash leading to net debt of about US$177.0m.
A Look At Watts Water Technologies's Liabilities
We can see from the most recent balance sheet that Watts Water Technologies had liabilities of US$391.6m falling due within a year, and liabilities of US$352.6m due beyond that. On the other hand, it had cash of US$166.8m and US$254.2m worth of receivables due within a year. So its liabilities total US$323.2m more than the combination of its cash and short-term receivables.
Since publicly traded Watts Water Technologies shares are worth a total of US$3.15b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Watts Water Technologies has a low net debt to EBITDA ratio of only 0.72. And its EBIT covers its interest expense a whopping 13.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Watts Water Technologies grew its EBIT by 8.7% in the last year, making that debt load look even more manageable. 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 Watts Water Technologies can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Watts Water Technologies produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, Watts Water Technologies's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, Watts Water Technologies seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Watts Water Technologies insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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