Does BAE Systems (LON:BA.) Have A Healthy Balance Sheet?

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 note that BAE Systems plc (LON:BA.) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the GB Aerospace & Defense industry.

What Is BAE Systems’s Debt?

As you can see below, BAE Systems had UK£5.19b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have UK£1.96b in cash offsetting this, leading to net debt of about UK£3.23b.

debt equity history analysis
LSE:BA. Debt to Equity History November 25th 2022

A Look At BAE Systems’ Liabilities

According to the last reported balance sheet, BAE Systems had liabilities of UK£8.78b due within 12 months, and liabilities of UK£9.61b due beyond 12 months. On the other hand, it had cash of UK£1.96b and UK£6.02b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£10.4b.

While this might seem like a lot, it is not so bad since BAE Systems has a huge market capitalization of UK£24.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

BAE Systems’s net debt of 1.5 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.7 times interest expense) certainly does not do anything to dispel this impression. On the other hand, BAE Systems’s EBIT dived 15%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analyzing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine BAE Systems’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. 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, BAE Systems recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.

OurView

On our analysis BAE Systems’s conversion of EBIT to free cash flow should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. In particular, EBIT growth rate gives us cold feet. Looking at all this data makes us feel a little cautious about BAE Systems’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check BAE Systems’s dividend history, without delay!

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.

Valuation is complex, but we’re helping make it simple.

Find out whether BAE Systems is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

View the Free Analysis

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.

Leave a Reply

Your email address will not be published. Required fields are marked *

Back to top button