Is Chemring Group (LON:CHG) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Chemring Group PLC (LON:CHG) does use debt in its business. But is this debt a concern to shareholders?

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When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Chemring Group's Debt?

The image below, which you can click on for greater detail, shows that at October 2024 Chemring Group had debt of UK£86.8m, up from UK£14.2m in one year. However, because it has a cash reserve of UK£45.0m, its net debt is less, at about UK£41.8m.

How Healthy Is Chemring Group's Balance Sheet?

According to the last reported balance sheet, Chemring Group had liabilities of UK£221.9m due within 12 months, and liabilities of UK£113.9m due beyond 12 months. Offsetting these obligations, it had cash of UK£45.0m as well as receivables valued at UK£82.6m due within 12 months. So it has liabilities totalling UK£208.2m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Chemring Group is worth UK£1.03b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

See our latest analysis for Chemring Group

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.

Chemring Group's net debt is only 0.50 times its EBITDA. And its EBIT easily covers its interest expense, being 12.8 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Chemring Group has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Chemring Group recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Chemring Group's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, EBIT growth rate gives us cold feet. Looking at all this data makes us feel a little cautious about Chemring Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Chemring Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.