David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Leidos Holdings, Inc. (NYSE:LDOS) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Leidos Holdings's Net Debt?
As you can see below, at the end of January 2021, Leidos Holdings had US$4.84b of debt, up from US$3.05b a year ago. Click the image for more detail. However, it does have US$524.0m in cash offsetting this, leading to net debt of about US$4.31b.
How Strong Is Leidos Holdings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Leidos Holdings had liabilities of US$2.91b due within 12 months and liabilities of US$5.73b due beyond that. Offsetting these obligations, it had cash of US$524.0m as well as receivables valued at US$2.14b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.98b.
While this might seem like a lot, it is not so bad since Leidos Holdings has a huge market capitalization of US$13.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Leidos Holdings's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 5.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If Leidos Holdings can keep growing EBIT at last year's rate of 15% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Leidos Holdings'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Leidos Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Leidos Holdings's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at all the aforementioned factors together, it strikes us that Leidos Holdings can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Be aware that Leidos Holdings is showing 2 warning signs in our investment analysis , you should know about...
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.
When trading Leidos Holdings or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
This article by Simply Wall St is general in nature. 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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.