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 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 General Dynamics Corporation (NYSE:GD) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does General Dynamics Carry?
The image below, which you can click on for greater detail, shows that General Dynamics had debt of US$11.5b at the end of April 2022, a reduction from US$13.2b over a year. However, because it has a cash reserve of US$2.91b, its net debt is less, at about US$8.59b.
How Healthy Is General Dynamics’ Balance Sheet?
We can see from the most recent balance sheet that General Dynamics had liabilities of US$14.0b falling due within a year, and liabilities of US$18.8b due beyond that. On the other hand, it had cash of US$2.91b and US$10.9b worth of receivables due within a year. So it has liabilities totalling US$19.1b more than its cash and near-term receivables, combined.
General Dynamics has a very large market capitalization of US$65.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We’d say that General Dynamics’s moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its commanding EBIT of 11.0 times its interest expense, implies the debt load is as light as a peacock feather. The good news is that General Dynamics has increased its EBIT by 3.5% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine General Dynamics’s ability to maintain a healthy balance sheet going forward.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, General Dynamics generated free cash flow amounting to a very robust 84% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
General Dynamics’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its interest cover is also very heartening. When we consider the range of factors above, it looks like General Dynamics is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt.