The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Lockheed Martin Corporation (NYSE:LMT) does carry debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Lockheed Martin’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Lockheed Martin had US$11.6b of debt in June 2020, down from US$13.5b, one year before. However, it also had US$2.86b in cash, and so its net debt is US$8.71b.
How Healthy Is Lockheed Martin’s Balance Sheet?
According to the last reported balance sheet, Lockheed Martin had liabilities of US$14.9b due within 12 months, and liabilities of US$30.9b due beyond 12 months. Offsetting this, it had US$2.86b in cash and US$12.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$30.3b.
While this might seem like a lot, it is not so bad since Lockheed Martin has a huge market capitalization of US$107.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Lockheed Martin has a low net debt to EBITDA ratio of only 0.93. And its EBIT covers its interest expense a whopping 13.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Lockheed Martin grew its EBIT at 13% over the last year, further increasing its ability to manage debt. 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 Lockheed Martin can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Lockheed Martin 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.
Happily, Lockheed Martin’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! When we consider the range of factors above, it looks like Lockheed Martin is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 1 warning sign for Lockheed Martin you should be aware of.
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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