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.' 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. We can see that BBA Aviation plc (LON:BBA) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does BBA Aviation Carry?
As you can see below, at the end of June 2019, BBA Aviation had US$1.49b of debt, up from US$1.34b a year ago. Click the image for more detail. On the flip side, it has US$116.7m in cash leading to net debt of about US$1.37b.
How Healthy Is BBA Aviation's Balance Sheet?
We can see from the most recent balance sheet that BBA Aviation had liabilities of US$712.0m falling due within a year, and liabilities of US$2.79b due beyond that. Offsetting this, it had US$116.7m in cash and US$257.9m in receivables that were due within 12 months. So it has liabilities totalling US$3.13b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$3.69b, so it does suggest shareholders should keep an eye on BBA Aviation's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While BBA Aviation's debt to EBITDA ratio (3.2) suggests that it uses some debt, its interest cover is very weak, at 2.3, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Fortunately, BBA Aviation grew its EBIT by 5.0% in the last year, slowly shrinking its debt relative to earnings. 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 BBA Aviation 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, while the tax-man may adore accounting profits, lenders only accept 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 last three years, BBA Aviation actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
When it comes to the balance sheet, the standout positive for BBA Aviation was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. We would also note that Infrastructure industry companies like BBA Aviation commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about BBA Aviation's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that BBA Aviation insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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