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 note that Lockheed Martin Corporation (NYSE:LMT) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Lockheed Martin's Net Debt?
The image below, which you can click on for greater detail, shows that Lockheed Martin had debt of US$13.5b at the end of June 2019, a reduction from US$14.2b over a year. However, it does have US$1.17b in cash offsetting this, leading to net debt of about US$12.4b.
How Healthy Is Lockheed Martin's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Lockheed Martin had liabilities of US$15.1b due within 12 months and liabilities of US$29.8b due beyond that. Offsetting these obligations, it had cash of US$1.17b as well as receivables valued at US$12.9b due within 12 months. So its liabilities total US$30.8b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Lockheed Martin is worth a massive US$106.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Lockheed Martin's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 11.7 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Lockheed Martin has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. 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 Lockheed Martin 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Lockheed Martin recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Lockheed Martin's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. When we consider the range of factors above, it looks like Lockheed Martin is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Lockheed Martin insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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