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.' 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 Meggitt PLC (LON:MGGT) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Meggitt Carry?
The image below, which you can click on for greater detail, shows that Meggitt had debt of UK£798.0m at the end of June 2021, a reduction from UK£1.08b over a year. However, it does have UK£139.3m in cash offsetting this, leading to net debt of about UK£658.7m.
How Strong Is Meggitt's Balance Sheet?
The latest balance sheet data shows that Meggitt had liabilities of UK£501.8m due within a year, and liabilities of UK£1.29b falling due after that. Offsetting these obligations, it had cash of UK£139.3m as well as receivables valued at UK£330.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.32b.
Meggitt has a market capitalization of UK£5.67b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt at just -9.4 times EBITDA, it seems Meggitt only uses a little bit of leverage. Although with EBIT only covering interest expenses 5.7 times over, the company is truly paying for borrowing. Shareholders should be aware that Meggitt's EBIT was down 44% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Meggitt 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. In the last three years, Meggitt's free cash flow amounted to 48% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Meggitt's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able handle its debt, based on its EBITDA, with ease. We think that Meggitt's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 Meggitt is showing 2 warning signs in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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