Here's Why Chemring Group (LON:CHG) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Chemring Group PLC (LON:CHG) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Chemring Group

What Is Chemring Group's Debt?

You can click the graphic below for the historical numbers, but it shows that Chemring Group had UK£37.9m of debt in April 2021, down from UK£158.6m, one year before. However, it does have UK£3.60m in cash offsetting this, leading to net debt of about UK£34.3m.

How Healthy Is Chemring Group's Balance Sheet?

According to the last reported balance sheet, Chemring Group had liabilities of UK£91.6m due within 12 months, and liabilities of UK£81.0m due beyond 12 months. Offsetting this, it had UK£3.60m in cash and UK£58.5m in receivables that were due within 12 months. So it has liabilities totalling UK£110.5m more than its cash and near-term receivables, combined.

Since publicly traded Chemring Group shares are worth a total of UK£859.4m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chemring Group's net debt is only 0.44 times its EBITDA. And its EBIT covers its interest expense a whopping 22.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Chemring Group grew its EBIT by 16% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chemring Group's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Chemring Group produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Chemring Group's interest cover 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 net debt to EBITDA also supports that impression! Looking at the bigger picture, we think Chemring Group's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Chemring Group is showing 1 warning sign in our investment analysis , you should know about...

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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