Pennon Group (LON:PNN) Use Of Debt Could Be Considered Risky

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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.' 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 note that Pennon Group Plc (LON:PNN) does have debt on its balance sheet. But is this debt a concern to shareholders?

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When Is Debt A Problem?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Pennon Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2025 Pennon Group had UK£3.50b of debt, an increase on UK£2.90b, over one year. However, it does have UK£417.9m in cash offsetting this, leading to net debt of about UK£3.09b.

A Look At Pennon Group's Liabilities

According to the last reported balance sheet, Pennon Group had liabilities of UK£596.0m due within 12 months, and liabilities of UK£5.00b due beyond 12 months. Offsetting these obligations, it had cash of UK£417.9m as well as receivables valued at UK£374.1m due within 12 months. So its liabilities total UK£4.80b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the UK£2.39b 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'd watch its balance sheet closely, without a doubt. After all, Pennon Group would likely require a major re-capitalisation if it had to pay its creditors today.

See our latest analysis for Pennon Group

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 shareholders face the double whammy of a high net debt to EBITDA ratio (10.7), and fairly weak interest coverage, since EBIT is just 0.78 times the interest expense. The debt burden here is substantial. Another concern for investors might be that Pennon Group's EBIT fell 17% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Pennon Group'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.

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. During the last three years, Pennon Group burned a lot of cash. 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

On the face of it, Pennon Group's conversion of EBIT to free cash flow 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. And furthermore, its net debt to EBITDA also fails to instill confidence. We should also note that Water Utilities industry companies like Pennon Group commonly do use debt without problems. It looks to us like Pennon Group carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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. Case in point: We've spotted 3 warning signs for Pennon Group 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.