Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Chemring Group PLC (LON:CHG) 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Chemring Group
What Is Chemring Group's Debt?
The image below, which you can click on for greater detail, shows that Chemring Group had debt of UK£57.6m at the end of October 2020, a reduction from UK£77.0m over a year. On the flip side, it has UK£14.7m in cash leading to net debt of about UK£42.9m.
A Look At Chemring Group's Liabilities
According to the last reported balance sheet, Chemring Group had liabilities of UK£111.8m due within 12 months, and liabilities of UK£100.0m due beyond 12 months. On the other hand, it had cash of UK£14.7m and UK£58.6m worth of receivables due within a year. So it has liabilities totalling UK£138.5m more than its cash and near-term receivables, combined.
Of course, Chemring Group has a market capitalization of UK£757.7m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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 0.58 times its EBITDA. And its EBIT covers its interest expense a whopping 16.6 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Chemring Group grew its EBIT by 48% 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 Chemring 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, Chemring Group produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
The good news is that Chemring Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Chemring Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Chemring Group that you should be aware of.
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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About LSE:CHG
Chemring Group
Provides countermeasures, sensors, information, and energetic products in the United States, the United Kingdom, Europe, the Asia pacific, and internationally.
Flawless balance sheet with reasonable growth potential.
