The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, Northrop Grumman Corporation (NYSE:NOC) does carry debt. 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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Northrop Grumman Carry?

The chart below, which you can click on for greater detail, shows that Northrop Grumman had US$16.3b in debt in June 2024; about the same as the year before. However, it does have US$3.27b in cash offsetting this, leading to net debt of about US$13.0b.

A Look At Northrop Grumman's Liabilities

We can see from the most recent balance sheet that Northrop Grumman had liabilities of US$12.9b falling due within a year, and liabilities of US$20.5b due beyond that. Offsetting these obligations, it had cash of US$3.27b as well as receivables valued at US$8.71b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$21.4b.

Northrop Grumman has a very large market capitalization of US$74.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Northrop Grumman's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.2 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Shareholders should be aware that Northrop Grumman's EBIT was down 50% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Northrop Grumman's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. In the last three years, Northrop Grumman's free cash flow amounted to 33% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Northrop Grumman's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Northrop Grumman stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Northrop Grumman you should know about.

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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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.