Here's Why Babcock International Group (LON:BAB) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Babcock International Group PLC (LON:BAB) does carry debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Babcock International Group

How Much Debt Does Babcock International Group Carry?

As you can see below, Babcock International Group had UK£746.8m of debt at September 2023, down from UK£1.77b a year prior. However, it also had UK£480.5m in cash, and so its net debt is UK£266.3m.

How Healthy Is Babcock International Group's Balance Sheet?

According to the last reported balance sheet, Babcock International Group had liabilities of UK£1.71b due within 12 months, and liabilities of UK£1.26b due beyond 12 months. Offsetting these obligations, it had cash of UK£480.5m as well as receivables valued at UK£795.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.69b.

This deficit is considerable relative to its market capitalization of UK£2.13b, so it does suggest shareholders should keep an eye on Babcock International Group's use of debt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Babcock International Group's net debt is only 0.91 times its EBITDA. And its EBIT easily covers its interest expense, being 10.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Babcock International Group has been able to increase its EBIT by 23% in twelve months, making it easier to pay down 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 Babcock International Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last two years, Babcock International Group's free cash flow amounted to 34% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Babcock International Group's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Babcock International Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Babcock International Group you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.