Is BAE Systems (LON:BA.) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies BAE Systems plc (LON:BA.) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for BAE Systems

How Much Debt Does BAE Systems Carry?

As you can see below, BAE Systems had UK£5.12b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has UK£3.20b in cash leading to net debt of about UK£1.92b.

How Strong Is BAE Systems' Balance Sheet?

According to the last reported balance sheet, BAE Systems had liabilities of UK£10.2b due within 12 months, and liabilities of UK£9.90b due beyond 12 months. On the other hand, it had cash of UK£3.20b and UK£6.49b worth of receivables due within a year. So it has liabilities totalling UK£10.4b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since BAE Systems has a huge market capitalization of UK£31.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt sitting at just 0.69 times EBITDA, BAE Systems is arguably pretty conservatively geared. And it boasts interest cover of 9.9 times, which is more than adequate. In addition to that, we're happy to report that BAE Systems has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

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 EBIT growth rate 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.

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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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.