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.' 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. We note that Otter Tail Corporation (NASDAQ:OTTR) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Otter Tail Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Otter Tail had debt of US$956.4m, up from US$874.1m in one year. However, it does have US$230.7m in cash offsetting this, leading to net debt of about US$725.7m.

How Strong Is Otter Tail's Balance Sheet?

According to the last reported balance sheet, Otter Tail had liabilities of US$271.0m due within 12 months, and liabilities of US$1.62b due beyond 12 months. Offsetting these obligations, it had cash of US$230.7m as well as receivables valued at US$191.9m due within 12 months. So its liabilities total US$1.47b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Otter Tail has a market capitalization of US$3.28b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Otter Tail has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 10.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Otter Tail grew its EBIT by 12% last year, making its debt load easier to handle. 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 Otter Tail 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Otter Tail's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Otter Tail was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. It's also worth noting that Otter Tail is in the Electric Utilities industry, which is often considered to be quite defensive. Considering this range of data points, we think Otter Tail is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Otter Tail (of which 1 is a bit unpleasant!) you should know about.

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.