Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies General Dynamics Corporation (NYSE:GD) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. When we think about a company's use of debt, we first look at cash and debt together.
What Is General Dynamics's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2020 General Dynamics had debt of US$14.6b, up from US$13.9b in one year. However, because it has a cash reserve of US$2.30b, its net debt is less, at about US$12.3b.
How Strong Is General Dynamics's Balance Sheet?
The latest balance sheet data shows that General Dynamics had liabilities of US$16.6b due within a year, and liabilities of US$19.7b falling due after that. Offsetting this, it had US$2.30b in cash and US$11.2b in receivables that were due within 12 months. So its liabilities total US$22.8b more than the combination of its cash and short-term receivables.
General Dynamics has a very large market capitalization of US$39.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a debt to EBITDA ratio of 2.3, General Dynamics uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.5 times interest expense) certainly does not do anything to dispel this impression. Unfortunately, General Dynamics saw its EBIT slide 3.1% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine General Dynamics's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. During the last three years, General Dynamics produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Neither General Dynamics's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that General Dynamics's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 1 warning sign for General Dynamics that you should be aware of before investing here.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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