Are Fortescue Metals Group Limited's (ASX:FMG) Interest Costs Too High?

Investors seeking to preserve capital in a volatile environment might consider large-cap stocks such as Fortescue Metals Group Limited (ASX:FMG) a safer option. Doing business globally, large caps tend to have diversified revenue streams and attractive capital returns, making them desirable investments for risk-averse portfolios. However, the key to extending previous success is in the health of the company’s financials. Today we will look at Fortescue Metals Group’s financial liquidity and debt levels, which are strong indicators for whether the company can weather economic downturns or fund strategic acquisitions for future growth. Note that this commentary is very high-level and solely focused on financial health, so I suggest you dig deeper yourself into FMG here.

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How much cash does FMG generate through its operations?

FMG has shrunken its total debt levels in the last twelve months, from US$4.5b to US$4.0b , which also accounts for long term debt. With this debt repayment, FMG's cash and short-term investments stands at US$863m for investing into the business. Moreover, FMG has generated US$1.6b in operating cash flow during the same period of time, leading to an operating cash to total debt ratio of 40%, signalling that FMG’s operating cash is sufficient to cover its debt. This ratio can also be a sign of operational efficiency as an alternative to return on assets. In FMG’s case, it is able to generate 0.4x cash from its debt capital.

Does FMG’s liquid assets cover its short-term commitments?

At the current liabilities level of US$1.2b, it seems that the business has been able to meet these commitments with a current assets level of US$1.7b, leading to a 1.33x current account ratio. Generally, for Metals and Mining companies, this is a reasonable ratio since there is a bit of a cash buffer without leaving too much capital in a low-return environment.

Can FMG service its debt comfortably?

FMG is a relatively highly levered company with a debt-to-equity of 41%. This is not unusual for large-caps since debt tends to be less expensive than equity because interest payments are tax deductible. Consequently, larger-cap organisations tend to enjoy lower cost of capital as a result of easily attained financing, providing an advantage over smaller companies. By measuring how many times FMG’s earnings can cover interest payments, we can evaluate whether its level of debt is sustainable or not. A company generating earnings before interest and tax (EBIT) at least three times its net interest payments is considered financially sound. In FMG's case, the ratio of 5.83x suggests that interest is appropriately covered. Large-cap investments like FMG are often believed to be a safe investment due to their ability to pump out ample earnings multiple times its interest payments.

Next Steps:

Although FMG’s debt level is towards the higher end of the spectrum, its cash flow coverage seems adequate to meet obligations which means its debt is being efficiently utilised. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. I admit this is a fairly basic analysis for FMG's financial health. Other important fundamentals need to be considered alongside. I suggest you continue to research Fortescue Metals Group to get a better picture of the large-cap by looking at:

1. Future Outlook: What are well-informed industry analysts predicting for FMG’s future growth? Take a look at our free research report of analyst consensus for FMG’s outlook.
2. Valuation: What is FMG worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether FMG is currently mispriced by the market.
3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.