Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Kratos Defense & Security Solutions's Debt?
As you can see below, Kratos Defense & Security Solutions had US$301.0m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$380.8m in cash offsetting this, leading to net cash of US$79.8m.
How Strong Is Kratos Defense & Security Solutions' Balance Sheet?
The latest balance sheet data shows that Kratos Defense & Security Solutions had liabilities of US$197.6m due within a year, and liabilities of US$425.1m falling due after that. On the other hand, it had cash of US$380.8m and US$272.3m worth of receivables due within a year. So it actually has US$30.4m more liquid assets than total liabilities.
This state of affairs indicates that Kratos Defense & Security Solutions' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$3.21b company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Kratos Defense & Security Solutions boasts net cash, so it's fair to say it does not have a heavy debt load!
Importantly, Kratos Defense & Security Solutions's EBIT fell a jaw-dropping 23% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Kratos Defense & Security Solutions 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Kratos Defense & Security Solutions may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Kratos Defense & Security Solutions basically broke even on a free cash flow basis. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
While we empathize with investors who find debt concerning, you should keep in mind that Kratos Defense & Security Solutions has net cash of US$79.8m, as well as more liquid assets than liabilities. So while Kratos Defense & Security Solutions does not have a great balance sheet, it's certainly not too bad. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Kratos Defense & Security Solutions (including 1 which is concerning) .
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.
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.
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