Fomento de Construcciones y Contratas (BME:FCC) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Fomento de Construcciones y Contratas, S.A. (BME:FCC) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Fomento de Construcciones y Contratas

How Much Debt Does Fomento de Construcciones y Contratas Carry?

As you can see below, Fomento de Construcciones y Contratas had €3.98b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has €1.31b in cash leading to net debt of about €2.67b.

A Look At Fomento de Construcciones y Contratas' Liabilities

The latest balance sheet data shows that Fomento de Construcciones y Contratas had liabilities of €4.42b due within a year, and liabilities of €5.60b falling due after that. Offsetting these obligations, it had cash of €1.31b as well as receivables valued at €2.12b due within 12 months. So it has liabilities totalling €6.59b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the €3.97b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Fomento de Construcciones y Contratas would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Fomento de Construcciones y Contratas's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 4.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Fomento de Construcciones y Contratas grew its EBIT by 6.0% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 Fomento de Construcciones y Contratas 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Fomento de Construcciones y Contratas produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Mulling over Fomento de Construcciones y Contratas's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Fomento de Construcciones y Contratas has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 4 warning signs for Fomento de Construcciones y Contratas you should be aware of, and 1 of them is significant.

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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