Stock Analysis

Northrop Grumman (NYSE:NOC) Takes On Some Risk With Its Use Of Debt

NYSE:NOC
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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.' 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. We note that Northrop Grumman Corporation (NYSE:NOC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Northrop Grumman

How Much Debt Does Northrop Grumman Carry?

As you can see below, Northrop Grumman had US$12.9b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$2.58b, its net debt is less, at about US$10.3b.

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NYSE:NOC Debt to Equity History March 20th 2023

How Healthy Is Northrop Grumman's Balance Sheet?

We can see from the most recent balance sheet that Northrop Grumman had liabilities of US$11.6b falling due within a year, and liabilities of US$16.9b due beyond that. On the other hand, it had cash of US$2.58b and US$8.34b worth of receivables due within a year. So its liabilities total US$17.5b more than the combination of its cash and short-term receivables.

Northrop Grumman has a very large market capitalization of US$67.5b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Northrop Grumman has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 12.5 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Northrop Grumman 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 ultimately the future profitability of the business will decide if Northrop Grumman 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Northrop Grumman's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Northrop Grumman's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Northrop Grumman is a somewhat risky investment as a result of its debt. 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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Northrop Grumman (including 1 which is potentially serious) .

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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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.