These 4 Measures Indicate That Fortescue Metals Group (ASX:FMG) Is Using Debt Safely

By
Simply Wall St
Published
June 21, 2021
ASX:FMG

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. 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?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Fortescue Metals Group

What Is Fortescue Metals Group's Debt?

As you can see below, Fortescue Metals Group had US$3.20b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. But it also has US$3.97b in cash to offset that, meaning it has US$771.0m net cash.

debt-equity-history-analysis
ASX:FMG Debt to Equity History June 21st 2021

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$2.89b falling due within a year, and liabilities of US$6.58b due beyond that. Offsetting this, it had US$3.97b in cash and US$988.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.50b.

Given Fortescue Metals Group has a humongous market capitalization of US$50.2b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Fortescue Metals Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

On top of that, Fortescue Metals Group grew its EBIT by 32% 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 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. 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. During the last three years, Fortescue Metals Group produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

We could understand if investors are concerned about Fortescue Metals Group's liabilities, but we can be reassured by the fact it has has net cash of US$771.0m. And it impressed us with its EBIT growth of 32% over the last year. So we don't think Fortescue Metals Group's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Fortescue Metals Group is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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. 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.
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