Is Educational Development (NASDAQ:EDUC) A Risky Investment?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Educational Development Corporation (NASDAQ:EDUC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Educational Development

What Is Educational Development's Net Debt?

The image below, which you can click on for greater detail, shows that Educational Development had debt of US$11.1m at the end of November 2020, a reduction from US$19.1m over a year. However, it does have US$31.5m in cash offsetting this, leading to net cash of US$20.4m.

A Look At Educational Development's Liabilities

Zooming in on the latest balance sheet data, we can see that Educational Development had liabilities of US$62.5m due within 12 months and liabilities of US$10.9m due beyond that. Offsetting these obligations, it had cash of US$31.5m as well as receivables valued at US$4.12m due within 12 months. So it has liabilities totalling US$37.8m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Educational Development is worth US$144.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Educational Development also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Educational Development has boosted its EBIT by 89%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Educational Development will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Educational Development 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, Educational Development actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although Educational Development's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$20.4m. The cherry on top was that in converted 140% of that EBIT to free cash flow, bringing in US$33m. So is Educational Development's debt a risk? It doesn't seem so to us. 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. To that end, you should be aware of the 1 warning sign we've spotted with Educational Development .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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.
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