Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies John Wiley & Sons, Inc. (NYSE:WLY) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does John Wiley & Sons Carry?
The image below, which you can click on for greater detail, shows that John Wiley & Sons had debt of US$919.2m at the end of January 2022, a reduction from US$967.2m over a year. On the flip side, it has US$109.4m in cash leading to net debt of about US$809.7m.
How Strong Is John Wiley & Sons’ Balance Sheet?
The latest balance sheet data shows that John Wiley & Sons had liabilities of US$821.5m due within a year, and liabilities of US$1.44b falling due after that. Offsetting these obligations, it had cash of US$109.4m as well as receivables valued at US$268.0m due within 12 months. So it has liabilities totalling US$1.88b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$2.88b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
We’d say that John Wiley & Sons’s moderate net debt to EBITDA ratio ( being 2.3), indicates prudence when it comes to debt. And its strong interest cover of 12.2 times, makes us even more comfortable. John Wiley & Sons grew its EBIT by 7.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine John Wiley & Sons’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, John Wiley & Sons recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
The good news is that John Wiley & Sons’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that John Wiley & Sons can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start.