Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 note that General Dynamics Corporation (NYSE:GD) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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 General Dynamics's Debt?
You can click the graphic below for the historical numbers, but it shows that General Dynamics had US$13.2b of debt in April 2021, down from US$18.0b, one year before. However, it does have US$1.81b in cash offsetting this, leading to net debt of about US$11.4b.
A Look At General Dynamics' Liabilities
We can see from the most recent balance sheet that General Dynamics had liabilities of US$15.2b falling due within a year, and liabilities of US$19.5b due beyond that. Offsetting these obligations, it had cash of US$1.81b as well as receivables valued at US$11.2b due within 12 months. So it has liabilities totalling US$21.6b more than its cash and near-term receivables, combined.
General Dynamics has a very large market capitalization of US$53.2b, 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). 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).
General Dynamics's net debt of 2.2 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.6 times its interest expenses harmonizes with that theme. Unfortunately, General Dynamics saw its EBIT slide 5.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, General Dynamics produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
General Dynamics's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about General Dynamics'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. 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. To that end, you should be aware of the 1 warning sign we've spotted with General Dynamics .
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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