Is Fortescue Metals Group (ASX:FMG) A Risky Investment?

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 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.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Fortescue Metals Group

What Is Fortescue Metals Group's Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Fortescue Metals Group had debt of US$3.84b, up from US$3.20b in one year. However, because it has a cash reserve of US$2.90b, its net debt is less, at about US$939.0m.

A Look At Fortescue Metals Group's Liabilities

The latest balance sheet data shows that Fortescue Metals Group had liabilities of US$2.15b due within a year, and liabilities of US$7.26b falling due after that. Offsetting this, it had US$2.90b in cash and US$491.0m in receivables that were due within 12 months. So its liabilities total US$6.01b more than the combination of its cash and short-term receivables.

Of course, Fortescue Metals Group has a titanic market capitalization of US$43.4b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Fortescue Metals Group has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.065 and EBIT of 107 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. On top of that, Fortescue Metals Group grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Fortescue Metals Group produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Fortescue Metals Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Fortescue Metals Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. For example, we've discovered 2 warning signs for Fortescue Metals Group (1 is a bit unpleasant!) that you should be aware of before investing here.

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.