Here's Why BAE Systems (LON:BA.) Can Manage Its Debt Responsibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, BAE Systems plc (LON:BA.) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for BAE Systems

What Is BAE Systems's Net Debt?

The chart below, which you can click on for greater detail, shows that BAE Systems had UK£5.28b in debt in December 2023; about the same as the year before. However, it also had UK£4.11b in cash, and so its net debt is UK£1.17b.

How Healthy Is BAE Systems' Balance Sheet?

According to the last reported balance sheet, BAE Systems had liabilities of UK£10.9b due within 12 months, and liabilities of UK£10.4b due beyond 12 months. Offsetting this, it had UK£4.11b in cash and UK£5.37b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£11.9b.

This deficit isn't so bad because BAE Systems is worth a massive UK£41.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

BAE Systems's net debt is only 0.41 times its EBITDA. And its EBIT covers its interest expense a whopping 11.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that BAE Systems grew its EBIT at 13% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if BAE Systems 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, BAE Systems actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

BAE Systems's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its interest cover also supports that impression! Zooming out, BAE Systems seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in BAE Systems, you may well want to click here to check an interactive graph of its earnings per share history.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.