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 synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Zurn Water Solutions Company (NYSE:ZWS) is in debt. But does this debt worry shareholders?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Zurn Water Solutions
How much debt does Zurn Water Solutions have?
The image below, which you can click on for more details, shows Zurn Water Solutions had $538.2 million in debt at the end of March 2022, a reduction from $1.12 billion year-over-year . On the other hand, it has $73.2 million in cash, resulting in a net debt of approximately $465.0 million.
How strong is Zurn Water Solutions’ balance sheet?
The latest balance sheet data shows that Zurn Water Solutions had liabilities of $214.5 million due within the year, and liabilities of $710.4 million due thereafter. As compensation for these obligations, it had cash of US$73.2 million and receivables valued at US$199.5 million due within 12 months. Thus, its liabilities total $652.2 million more than the combination of its cash and short-term receivables.
Of course, Zurn Water Solutions has a market capitalization of US$3.39 billion, so those liabilities are probably manageable. That said, it is clear that we must continue to monitor its record, lest it deteriorate.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Zurn Water Solutions’ net debt is at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense at just 4.5 times last year. While these numbers don’t alarm us, it’s worth noting that the cost of corporate debt has a real impact. We note that Zurn Water Solutions has increased its EBIT by 25% over the past year, which should facilitate debt repayment in the future. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Zurn Water Solutions’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Zurn Water Solutions has actually produced more free cash flow than EBIT. There’s nothing better than cash coming in to stay in your lenders’ good books.
Our point of view
The good news is that Zurn Water Solutions’ demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told, we think his coverage of interest somewhat undermines that impression. When we consider the range of factors above, it appears that Zurn Water Solutions is quite sensitive with its use of debt. While this carries some risk, it can also improve shareholder returns. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 5 warning signs for Zurn Water Solutions you should be aware, and 1 of them is a bit unpleasant.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.