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

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Fomento de Construcciones y Contratas, S.A. (BME:FCC) does carry debt. But is this debt a concern to shareholders?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Fomento de Construcciones y Contratas

What Is Fomento de Construcciones y Contratas's Debt?

The chart below, which you can click on for greater detail, shows that Fomento de Construcciones y Contratas had €4.94b in debt in December 2022; about the same as the year before. However, it also had €1.74b in cash, and so its net debt is €3.21b.

How Strong Is Fomento de Construcciones y Contratas' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fomento de Construcciones y Contratas had liabilities of €4.30b due within 12 months and liabilities of €6.05b due beyond that. On the other hand, it had cash of €1.74b and €2.41b worth of receivables due within a year. So it has liabilities totalling €6.20b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the €3.87b 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Fomento de Construcciones y Contratas has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.0 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. If Fomento de Construcciones y Contratas can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Fomento de Construcciones y Contratas'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Fomento de Construcciones y Contratas recorded free cash flow worth 73% 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

Fomento de Construcciones y Contratas's level of total liabilities was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. Looking at all the angles mentioned above, it does seem to us that Fomento de Construcciones y Contratas is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Fomento de Construcciones y Contratas you should know about.

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.