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. As with many other companies Booz Allen Hamilton Holding Corporation (NYSE:BAH) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Booz Allen Hamilton Holding's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Booz Allen Hamilton Holding had debt of US$2.16b, up from US$1.80b in one year. However, it also had US$653.1m in cash, and so its net debt is US$1.51b.
A Look At Booz Allen Hamilton Holding's Liabilities
We can see from the most recent balance sheet that Booz Allen Hamilton Holding had liabilities of US$1.21b falling due within a year, and liabilities of US$2.55b due beyond that. On the other hand, it had cash of US$653.1m and US$1.41b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.70b.
Since publicly traded Booz Allen Hamilton Holding shares are worth a very impressive total of US$10.5b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Booz Allen Hamilton Holding has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.7 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. If Booz Allen Hamilton Holding can keep growing EBIT at last year's rate of 12% 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 ultimately the future profitability of the business will decide if Booz Allen Hamilton Holding can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Booz Allen Hamilton Holding recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Booz Allen Hamilton Holding's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And its EBIT growth rate is good too. Looking at all the aforementioned factors together, it strikes us that Booz Allen Hamilton Holding 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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Booz Allen Hamilton Holding's earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.