Is BAE Systems plc Dependent On Debt?

A Tough Week For BAE

As all Foolish investors know, a sudden drop in a company’s share price can present a golden opportunity to buy in and increase the prospect of long-term gains.

Of course, shares normally don’t fall without reason and BAE’s (LSE: BA) (NASDAQOTH: BAESY.US) 10% fall this week was no exception. Indeed, the company reported that profits in 2013 fell by around two-thirds, mainly as a result of a significant impairment charge. Furthermore, the company lowered guidance for 2014, stating that earnings per share (EPS) would be around 5% – 10% lower than in 2013.

With this in mind, is BAE still financially sound and worth picking up on a long-term view? Or is it dependent on debt and too risky to add to a Foolish portfolio?

Excessive Debt Levels?

With a debt to equity ratio of 86%, BAE’s financial gearing is moderately high. Certainly, its balance sheet could accommodate more debt but, with interest rates set to increase over the next few years, it would be prudent for BAE to not gear up the balance sheet too much more than it is at present.

Indeed, with every £1 of net assets being matched by £0.85 of debt, BAE’s capital structure is aimed at improving returns to shareholders via a higher degree of risk. However, the risk of the company being unable to make interest payments on its debt appears to be slim. The two-thirds fall in profit was due to an impairment charge, which is a one-off item. Even with the charge included, BAE was still able to pay the interest on its debt 1.8 times, a level that appears adequate and is also likely to improve as 2014’s profits are forecast to be far higher than those of 2013.

Looking Ahead

As mentioned, BAE has reduced guidance for 2014’s bottom-line. However, even the reduced figure should provide the company with substantially more headroom when making interest payments than it had in 2013.

Furthermore, BAE is still expected to deliver earnings growth in 2014 and, trading on a price to earnings (P/E) ratio of 9.4, it looks good value at the current price of around £4. This, allied to its financial soundness, means that BAE could yet be prove to be a relatively strong performer during the rest of the year.