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. We can see that Aris Water Solutions, Inc. (NYSE:ARIS) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Aris Water Solutions's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Aris Water Solutions had debt of US$446.6m, up from US$423.9m in one year. However, because it has a cash reserve of US$11.5m, its net debt is less, at about US$435.1m.

How Strong Is Aris Water Solutions' Balance Sheet?

The latest balance sheet data shows that Aris Water Solutions had liabilities of US$94.9m due within a year, and liabilities of US$580.0m falling due after that. Offsetting these obligations, it had cash of US$11.5m as well as receivables valued at US$106.9m due within 12 months. So it has liabilities totalling US$556.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Aris Water Solutions is worth US$943.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Aris Water Solutions's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 2.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Aris Water Solutions's EBIT shot up like bamboo after rain, gaining 41% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Aris Water Solutions 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Aris Water Solutions saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Aris Water Solutions's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Aris Water Solutions is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Aris Water Solutions you should be aware of, and 1 of them doesn't sit too well with us.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.