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.’ 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, Vectrus, Inc. (NYSE:VEC) does carry debt. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Vectrus’s Debt?
As you can see below, Vectrus had US$73.0m of debt at March 2019, down from US$76.3m a year prior. However, it also had US$48.2m in cash, and so its net debt is US$24.7m.
A Look At Vectrus’s Liabilities
The latest balance sheet data shows that Vectrus had liabilities of US$234.6m due within a year, and liabilities of US$130.2m falling due after that. On the other hand, it had cash of US$48.2m and US$244.1m worth of receivables due within a year. So its liabilities total US$72.5m more than the combination of its cash and short-term receivables.
Since publicly traded Vectrus shares are worth a total of US$487.2m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Since Vectrus does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Vectrus has net debt of just 0.44 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.55 times, which is more than adequate. On top of that, Vectrus grew its EBIT by 37% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Vectrus can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Vectrus recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Vectrus’s impressive EBIT growth rate implies it has the upper hand on its debt. And that’s just the beginning of the good news since its interest cover is also very heartening. Zooming out, Vectrus seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. We’d be motivated to research the stock further if we found out that Vectrus insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.