Pearson (LON:PSON) seems to be using debt quite wisely
David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that Pearson plc (LON:PSON) has debt on its balance sheet. But should shareholders worry about its use of debt?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for Pearson
What is Pearson’s debt?
The image below, which you can click on for more details, shows Pearson had £801.0m in debt at the end of December 2021, a reduction from £1.02bn year on year . However, his balance sheet shows he is holding £937.0m in cash, so he actually has a net cash of £136.0m.
How healthy is Pearson’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Pearson had liabilities of £1.58 billion due within 12 months and liabilities of £1.48 billion due beyond. As compensation for these obligations, it had cash of £937.0 million as well as receivables valued at £1.28 billion and due within 12 months. Thus, its liabilities total £843.0 million more than the combination of its cash and short-term receivables.
Of course, Pearson has a market capitalization of £5.07 billion, so those liabilities are probably manageable. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future. While he has liabilities to note, Pearson also has more cash than debt, so we’re pretty confident he can manage his debt safely.
Importantly, Pearson’s EBIT has fallen 23% over the last twelve months. If this decline continues, it will be more difficult to repay debts than to sell foie gras at a vegan convention. The balance sheet is clearly the area to focus on when analyzing debt. But it’s future earnings, more than anything, that will determine Pearson’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay off its debts with paper profits; he needs cash. Pearson may have net cash on the balance sheet, but it is always interesting to see how well the company converts its earnings before interest and taxes (EBIT) into free cash flow, as this will influence both its need and its ability to manage debt. Over the past three years, Pearson has recorded free cash flow of 73% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Although Pearson has more liabilities than liquid assets, it also has a net cash position of £136.0m. And it impressed us with free cash flow of £150m, or 73% of its EBIT. So we have no problem with Pearson’s use of debt. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for Pearson you should know.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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