Fortescue Metals Group (ASX:FMG) Could Easily Take On More Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Fortescue Metals Group Limited (ASX:FMG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Fortescue Metals Group

What Is Fortescue Metals Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Fortescue Metals Group had US$4.23b of debt, an increase on US$3.38b, over one year. However, its balance sheet shows it holds US$4.86b in cash, so it actually has US$621.0m net cash.

A Look At Fortescue Metals Group's Liabilities

We can see from the most recent balance sheet that Fortescue Metals Group had liabilities of US$2.80b falling due within a year, and liabilities of US$7.36b due beyond that. Offsetting these obligations, it had cash of US$4.86b as well as receivables valued at US$543.0m due within 12 months. So its liabilities total US$4.76b more than the combination of its cash and short-term receivables.

Given Fortescue Metals Group has a humongous market capitalization of US$36.6b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Fortescue Metals Group boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Fortescue Metals Group grew its EBIT by 46% over the last twelve months, and that growth will make it easier to handle its debt. 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 Fortescue Metals Group 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Fortescue Metals Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Fortescue Metals Group recorded free cash flow worth 63% 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.

Summing up

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$621.0m. And it impressed us with its EBIT growth of 46% over the last year. 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. Be aware that Fortescue Metals Group is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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