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 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. Importantly, Scholastic Corporation (NASDAQ:SCHL) does carry debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Scholastic Carry?
You can click the graphic below for the historical numbers, but it shows that Scholastic had US$13.0m of debt in August 2019, down from US$15.7m, one year before. However, its balance sheet shows it holds US$199.4m in cash, so it actually has US$186.4m net cash.
How Healthy Is Scholastic's Balance Sheet?
We can see from the most recent balance sheet that Scholastic had liabilities of US$625.4m falling due within a year, and liabilities of US$122.5m due beyond that. On the other hand, it had cash of US$199.4m and US$226.1m worth of receivables due within a year. So its liabilities total US$322.4m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Scholastic has a market capitalization of US$1.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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, Scholastic also has more cash than debt, so we're pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for Scholastic if management cannot prevent a repeat of the 62% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Scholastic's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Scholastic may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Scholastic produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While Scholastic does have more liabilities than liquid assets, it also has net cash of US$186.4m. So we are not troubled with Scholastic's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Scholastic insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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