We believe Severn Trent (LON: SVT) is taking risks with his debt
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Above all, Severn Trent Plc (LON: SVT) is in debt. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.
Check out our latest analysis for Severn Trent
How much debt does Severn Trent have?
The graph below, which you can click for more details, shows Severn Trent owed Â£ 6.35 billion in debt as of September 2021; about the same as the year before. Net debt is about the same because it doesn’t have a lot of cash.
How strong is Severn Trent’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Severn Trent had a liability of Â£ 958.3million due within 12 months and a liability of Â£ 9.07 billion beyond. In compensation for these obligations, it had cash of Â£ 53.9 million as well as receivables valued at Â£ 551.0 million maturing within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by Â£ 9.43 billion.
When you consider that this deficit exceeds the company’s Â£ 7.36 billion market cap, you might well be inclined to take a close look at the balance sheet. Hypothetically, extremely high dilution would be required if the company were forced to repay its debts by raising capital at the current share price.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Severn Trent shareholders face the double whammy of a high net debt to EBITDA ratio (7.5) and fairly low interest coverage, since EBIT is only 2.4 times interest debtors. This means that we would consider him to be in heavy debt. Given the leverage, it is not ideal that Severn Trent’s EBIT has been fairly stable over the past twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But it is future profits, more than anything, that will determine Severn Trent’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Severn Trent’s free cash flow has been 28% of its EBIT, less than we expected. This low cash conversion makes debt management more difficult.
Our point of view
To be frank, Severn Trent’s level of total liabilities and his track record of managing his debt, based on his EBITDA, makes us rather uncomfortable with his debt levels. But at least its EBIT growth rate isn’t that bad. It’s also worth noting that water utility companies like Severn Trent generally use debt without a problem. Overall, it seems to us that Severn Trent’s track record is really very risky for the company. We are therefore almost as wary of this stock as a hungry kitten falls into its owner’s fish pond: once bitten, twice shy, as they say. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we have identified 3 warning signs for Severn Trent (1 is not doing too well with us) you should be aware of.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.