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 Huntington Ingalls Industries, Inc. (NYSE:HII) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Huntington Ingalls Industries's Net Debt?
As you can see below, at the end of June 2019, Huntington Ingalls Industries had US$1.70b of debt, up from US$1.28b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.
A Look At Huntington Ingalls Industries's Liabilities
Zooming in on the latest balance sheet data, we can see that Huntington Ingalls Industries had liabilities of US$1.90b due within 12 months and liabilities of US$3.70b due beyond that. Offsetting this, it had US$29.0m in cash and US$1.82b in receivables that were due within 12 months. So it has liabilities totalling US$3.75b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Huntington Ingalls Industries has a market capitalization of US$8.75b, 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
We'd say that Huntington Ingalls Industries's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 21.5 times, makes us even more comfortable. But the other side of the story is that Huntington Ingalls Industries saw its EBIT decline by 8.2% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Huntington Ingalls Industries can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Huntington Ingalls Industries's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Huntington Ingalls Industries's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Huntington Ingalls Industries is a somewhat risky investment as a result of its debt. 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. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.