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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Scholastic Corporation (NASDAQ:SCHL) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Scholastic's Debt?
You can click the graphic below for the historical numbers, but it shows that Scholastic had US$13.7m of debt in February 2022, down from US$190.7m, one year before. But on the other hand it also has US$308.9m in cash, leading to a US$295.2m net cash position.
A Look At Scholastic's Liabilities
We can see from the most recent balance sheet that Scholastic had liabilities of US$659.2m falling due within a year, and liabilities of US$96.0m due beyond that. Offsetting this, it had US$308.9m in cash and US$310.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$135.7m.
Given Scholastic has a market capitalization of US$1.21b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Scholastic boasts net cash, so it's fair to say it does not have a heavy debt load!
Although Scholastic made a loss at the EBIT level, last year, it was also good to see that it generated US$69m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Scholastic's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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. Over the last year, Scholastic 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.
Although Scholastic'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$295.2m. The cherry on top was that in converted 252% of that EBIT to free cash flow, bringing in US$175m. So we don't think Scholastic's use of debt is risky. 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. To that end, you should learn about the 2 warning signs we've spotted with Scholastic (including 1 which is significant) .
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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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.