Pennon Group (LON:PNN) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Pennon Group Plc (LON:PNN) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Pennon Group

What Is Pennon Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Pennon Group had UK£1.99b of debt, an increase on UK£1.44b, over one year. On the flip side, it has UK£357.3m in cash leading to net debt of about UK£1.63b.

A Look At Pennon Group's Liabilities

We can see from the most recent balance sheet that Pennon Group had liabilities of UK£415.2m falling due within a year, and liabilities of UK£3.64b due beyond that. Offsetting these obligations, it had cash of UK£357.3m as well as receivables valued at UK£264.8m due within 12 months. So it has liabilities totalling UK£3.44b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of UK£2.63b, we think shareholders really should watch Pennon Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Pennon Group's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 2.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On the other hand, Pennon Group grew its EBIT by 25% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Pennon Group 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Pennon Group created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Pennon Group's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Water Utilities industry companies like Pennon Group commonly do use debt without problems. Overall, we think it's fair to say that Pennon Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Pennon Group has 3 warning signs (and 2 which are concerning) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.