David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 note that Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is Kratos Defense & Security Solutions’s Debt?
The chart below, which you can click on for greater detail, shows that Kratos Defense & Security Solutions had US$296.5m in debt in September 2021; about the same as the year before. However, its balance sheet shows it holds US$369.9m in cash, so it actually has US$73.4m net cash.
How Strong Is Kratos Defense & Security Solutions’ Balance Sheet?
We can see from the most recent balance sheet that Kratos Defense & Security Solutions had liabilities of US$210.6m falling due within a year, and liabilities of US$410.3m due beyond 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 while it’s hard to imagine that the US$2.41b company is struggling for cash, we still think it’s worth monitoring its 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!
The bad news is that Kratos Defense & Security Solutions saw its EBIT decline by 11% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. 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. In the last three years, Kratos Defense & Security Solutions created free cash flow amounting to 11% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
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. When analysing debt levels, the balance sheet is the obvious place to start.