Pendragon (LON:PDG) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Pendragon PLC (LON:PDG) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that PDG is potentially undervalued!

What Is Pendragon's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Pendragon had debt of UK£93.9m, up from UK£73.7m in one year. However, its balance sheet shows it holds UK£96.7m in cash, so it actually has UK£2.80m net cash.

How Healthy Is Pendragon's Balance Sheet?

The latest balance sheet data shows that Pendragon had liabilities of UK£808.1m due within a year, and liabilities of UK£373.5m falling due after that. On the other hand, it had cash of UK£96.7m and UK£122.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£962.3m.

The deficiency here weighs heavily on the UK£281.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Pendragon would probably need a major re-capitalization if its creditors were to demand repayment. Pendragon boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Notably, Pendragon's EBIT launched higher than Elon Musk, gaining a whopping 111% on last year. 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 Pendragon's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Pendragon 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 last three years, Pendragon recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing Up

While Pendragon does have more liabilities than liquid assets, it also has net cash of UK£2.80m. And it impressed us with its EBIT growth of 111% over the last year. Despite its cash we think that Pendragon seems to struggle to handle its total liabilities, so we are wary of the stock. 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 2 warning signs for Pendragon you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.