We Think Fortescue (ASX:FMG) Can Stay On Top Of Its 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 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 Ltd (ASX:FMG) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Our free stock report includes 2 warning signs investors should be aware of before investing in Fortescue. Read for free now.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

How Much Debt Does Fortescue Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 Fortescue had US$4.85b of debt, an increase on US$4.58b, over one year. However, because it has a cash reserve of US$3.41b, its net debt is less, at about US$1.44b.

How Healthy Is Fortescue's Balance Sheet?

We can see from the most recent balance sheet that Fortescue had liabilities of US$2.17b falling due within a year, and liabilities of US$7.85b due beyond that. Offsetting these obligations, it had cash of US$3.41b as well as receivables valued at US$697.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.92b.

Of course, Fortescue has a titanic market capitalization of US$30.5b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

See our latest analysis for Fortescue

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Fortescue's net debt is only 0.17 times its EBITDA. And its EBIT easily covers its interest expense, being 56.0 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Fortescue's saving grace is its low debt levels, because its EBIT has tanked 38% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Fortescue recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Based on what we've seen Fortescue is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Fortescue is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Fortescue (1 doesn't sit too well with us!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.