Fagron (EBR:FAGR) Seems To Use Debt Quite Sensibly

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 can see that Fagron NV (EBR:FAGR) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Fagron

What Is Fagron's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Fagron had €378.4m of debt, an increase on €337.7m, over one year. On the flip side, it has €112.5m in cash leading to net debt of about €265.9m.

How Healthy Is Fagron's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fagron had liabilities of €241.6m due within 12 months and liabilities of €338.0m due beyond that. Offsetting these obligations, it had cash of €112.5m as well as receivables valued at €67.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €399.5m.

While this might seem like a lot, it is not so bad since Fagron has a market capitalization of €1.41b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Fagron has net debt to EBITDA of 2.5 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.3 times its interest expense, and its net debt to EBITDA, was quite high, at 2.5. One way Fagron could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. 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 Fagron 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Fagron produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Fagron's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. It's also worth noting that Fagron is in the Healthcare industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like Fagron is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Fagron you should be aware of.

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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