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. 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. We can see that Fortescue Metals Group Limited (ASX:FMG) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Fortescue Metals Group’s Debt?
You can click the graphic below for the historical numbers, but it shows that Fortescue Metals Group had US$3.20b of debt in December 2019, down from US$3.39b, one year before. However, it does have US$3.31b in cash offsetting this, leading to net cash of US$110.0m.
How Strong Is Fortescue Metals Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Fortescue Metals Group had liabilities of US$2.41b due within 12 months and liabilities of US$6.37b due beyond that. Offsetting these obligations, it had cash of US$3.31b as well as receivables valued at US$474.0m due within 12 months. So it has liabilities totalling US$4.99b more than its cash and near-term receivables, combined.
Fortescue Metals Group has a very large market capitalization of US$18.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Fortescue Metals Group boasts net cash, so it’s fair to say it does not have a heavy debt load!
Better yet, Fortescue Metals Group grew its EBIT by 328% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Fortescue Metals Group’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. Fortescue Metals Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Fortescue Metals Group recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Fortescue Metals Group’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$110.0m. And we liked the look of last year’s 328% year-on-year EBIT growth. So we don’t think Fortescue Metals Group’s use of debt is risky. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – Fortescue Metals Group has 2 warning signs (and 1 which shouldn’t be ignored) we think 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.
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.
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