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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Watts Water Technologies, Inc. (NYSE:WTS) does carry debt. But should shareholders be worried about its use of debt?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Watts Water Technologies Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Watts Water Technologies had US$213.8m of debt, an increase on US$98.2m, over one year. However, it does have US$306.5m in cash offsetting this, leading to net cash of US$92.7m.

A Look At Watts Water Technologies' Liabilities

We can see from the most recent balance sheet that Watts Water Technologies had liabilities of US$417.5m falling due within a year, and liabilities of US$292.5m due beyond that. On the other hand, it had cash of US$306.5m and US$291.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$111.9m.

Having regard to Watts Water Technologies' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$7.19b company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Watts Water Technologies boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Watts Water Technologies grew its EBIT by 14% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Watts Water Technologies'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. While Watts Water Technologies has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Watts Water Technologies recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Watts Water Technologies has US$92.7m in net cash. And it impressed us with free cash flow of US$298m, being 68% of its EBIT. So we don't think Watts Water Technologies's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Watts Water Technologies is showing 1 warning sign in our investment analysis , you should know about...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.