These 4 Measures Indicate That Pennon Group (LON:PNN) Is Using Debt Extensively

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. As with many other companies Pennon Group Plc (LON:PNN) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Pennon Group

What Is Pennon Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Pennon Group had UK£1.64b of debt in September 2020, down from UK£2.11b, one year before. But it also has UK£2.24b in cash to offset that, meaning it has UK£607.4m net cash.

How Healthy Is Pennon Group's Balance Sheet?

According to the last reported balance sheet, Pennon Group had liabilities of UK£180.0m due within 12 months, and liabilities of UK£3.46b due beyond 12 months. Offsetting these obligations, it had cash of UK£2.24b as well as receivables valued at UK£203.7m due within 12 months. So it has liabilities totalling UK£1.20b more than its cash and near-term receivables, combined.

Pennon Group has a market capitalization of UK£4.02b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Pennon Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Notably Pennon Group's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Pennon Group 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. Considering the last three years, Pennon Group actually recorded a cash outflow, overall. 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

Although Pennon Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£607.4m. So while Pennon Group does not have a great balance sheet, it's certainly not too bad. 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. For example, we've discovered 4 warning signs for Pennon Group (2 make us uncomfortable!) that you should be aware of before investing here.

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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