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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. 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. If things get really bad, the lenders can take control of the business. 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.
How Much Debt Does Northrop Grumman Carry?
As you can see below, Northrop Grumman had US$14.7b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has US$1.09b in cash leading to net debt of about US$13.6b.
A Look At Northrop Grumman's Liabilities
The latest balance sheet data shows that Northrop Grumman had liabilities of US$8.16b due within a year, and liabilities of US$22.2b falling due after that. On the other hand, it had cash of US$1.09b and US$7.49b worth of receivables due within a year. So it has liabilities totalling US$21.8b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Northrop Grumman has a huge market capitalization of US$62.9b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt to EBITDA of 2.6 Northrop Grumman has a fairly noticeable amount of debt. But the high interest coverage of 7.8 suggests it can easily service that debt. The bad news is that Northrop Grumman saw its EBIT decline by 13% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Northrop Grumman recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Northrop Grumman's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. 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. Given our hesitation about the stock, it would be good to know if Northrop Grumman insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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