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We Think Kratos Defense & Security Solutions (NASDAQ:KTOS) Is Taking Some Risk With Its Debt

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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Kratos Defense & Security Solutions

How Much Debt Does Kratos Defense & Security Solutions Carry?

As you can see below, Kratos Defense & Security Solutions had US$296.5m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds US$369.9m in cash, so it actually has US$73.4m net cash.

debt-equity-history-analysis
debt-equity-history-analysis

A Look At Kratos Defense & Security Solutions' Liabilities

The latest balance sheet data shows that Kratos Defense & Security Solutions had liabilities of US$210.6m due within a year, and liabilities of US$410.3m falling due after that. On the other hand, it had cash of US$369.9m and US$274.7m worth of receivables due within a year. So it actually has US$23.7m 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$2.48b 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!

Unfortunately, Kratos Defense & Security Solutions's EBIT flopped 11% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kratos Defense & Security Solutions's ability to maintain a healthy balance sheet going forward. 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. While Kratos Defense & Security Solutions has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Kratos Defense & Security Solutions reported free cash flow worth 11% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Kratos Defense & Security Solutions has US$73.4m in net cash and a decent-looking balance sheet. So although we see some areas for improvement, we're not too worried about Kratos Defense & Security Solutions's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Kratos Defense & Security Solutions .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.