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. Importantly, Northrop Grumman Corporation (NYSE:NOC) does carry debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Northrop Grumman's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Northrop Grumman had US$12.5b of debt in March 2021, down from US$16.8b, one year before. However, it also had US$3.52b in cash, and so its net debt is US$9.03b.
A Look At Northrop Grumman's Liabilities
The latest balance sheet data shows that Northrop Grumman had liabilities of US$8.37b due within a year, and liabilities of US$22.5b falling due after that. Offsetting these obligations, it had cash of US$3.52b as well as receivables valued at US$7.23b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$20.2b.
Northrop Grumman has a very large market capitalization of US$58.4b, 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's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 6.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. In addition to that, we're happy to report that Northrop Grumman has boosted its EBIT by 37%, thus reducing the spectre of future debt repayments. 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 Northrop Grumman'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Northrop Grumman produced sturdy free cash flow equating to 76% 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.
Northrop Grumman's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Northrop Grumman's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Northrop Grumman (at least 1 which is concerning) , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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