Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies Parsons Society (NYSE:PSN) uses debt. But the real question is whether this debt makes the business risky.

When is debt dangerous?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, 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 at a low price, thereby permanently diluting shareholders. 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 Parsons

What is Parsons Net Debt?

As you can see below, Parsons had $592.5 million in debt as of March 2022, up from $640.3 million the previous year. However, he has $285.6 million in cash to offset this, resulting in a net debt of approximately $306.8 million.

How strong is Parsons’ balance sheet?

According to the last published balance sheet, Parsons had liabilities of $1.01 billion due within 12 months and liabilities of $849.4 million due beyond 12 months. In compensation for these obligations, it had cash of 285.6 million US dollars as well as receivables valued at 1.25 billion US dollars and payable within 12 months. It therefore has liabilities totaling $326.4 million more than its cash and short-term receivables, combined.

Of course, Parsons has a market capitalization of US$3.98 billion, so those liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without depreciation and amortization charges.

While Parsons’ low debt-to-EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered interest expense by 6.6 times last year makes us reflect. We therefore recommend that you closely monitor the impact of financing costs on the business. In fact, Parsons’ saving grace is its low level of leverage, as its EBIT has fallen 22% over the past twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Parsons can strengthen its balance sheet over time. 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 debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Parsons has actually produced more free cash flow than EBIT. There’s nothing better than incoming money to stay in the good books of your lenders.

Our point of view

Based on what we’ve seen, Parsons doesn’t find it easy, given its EBIT growth rate, but the other factors we’ve considered give us cause for optimism. In particular, we are blown away by its conversion of EBIT to free cash flow. Given this range of data points, we believe Parsons is in a good position to manage its level of leverage. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. Of course, we wouldn’t say no to the extra confidence we’d gain if we knew Parsons insiders bought stock: if you’re on the same page, you can find out if insiders are buying by clicking this link. .

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.