Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Kaman Corporation (NYSE:KAMN) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Kaman’s Debt?
You can click the graphic below for the historical numbers, but it shows that Kaman had US$186.4m of debt in April 2021, down from US$383.6m, one year before. However, it also had US$120.7m in cash, and so its net debt is US$65.7m.
How Strong Is Kaman’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kaman had liabilities of US$159.8m due within 12 months and liabilities of US$323.7m due beyond that. Offsetting these obligations, it had cash of US$120.7m as well as receivables valued at US$221.8m due within 12 months. So its liabilities total US$141.0m more than the combination of its cash and short-term receivables.
Given Kaman has a market capitalization of US$1.44b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Looking at its net debt to EBITDA of 0.60 and interest cover of 3.3 times, it seems to us that Kaman is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Kaman saw its EBIT slide 8.5% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Kaman can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Kaman created free cash flow amounting to 12% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Kaman’s conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able handle its debt, based on its EBITDA, with ease. We think that Kaman’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.