Is Fomento de Construcciones y Contratas (BME:FCC) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Fomento de Construcciones y Contratas, S.A. (BME:FCC) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Fomento de Construcciones y Contratas

What Is Fomento de Construcciones y Contratas's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 Fomento de Construcciones y Contratas had €4.90b of debt, an increase on €4.19b, over one year. On the flip side, it has €1.68b in cash leading to net debt of about €3.22b.

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

The latest balance sheet data shows that Fomento de Construcciones y Contratas had liabilities of €4.24b due within a year, and liabilities of €5.57b falling due after that. Offsetting this, it had €1.68b in cash and €2.28b in receivables that were due within 12 months. So it has liabilities totalling €5.85b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's €4.33b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Fomento de Construcciones y Contratas has net debt to EBITDA of 3.1 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.1. Also relevant is that Fomento de Construcciones y Contratas has grown its EBIT by a very respectable 21% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Fomento de Construcciones y Contratas's free cash flow amounted to 48% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Fomento de Construcciones y Contratas's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its EBIT growth rate was re-invigorating. When we consider all the factors discussed, it seems to us that Fomento de Construcciones y Contratas is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. 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 2 of them 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. 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.