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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Fomento de Construcciones y Contratas, S.A. (BME:FCC) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Fomento de Construcciones y Contratas

What Is Fomento de Construcciones y Contratas's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Fomento de Construcciones y Contratas had debt of €4.77b, up from €3.64b in one year. However, it does have €1.30b in cash offsetting this, leading to net debt of about €3.46b.

A Look At Fomento de Construcciones y Contratas' Liabilities

We can see from the most recent balance sheet that Fomento de Construcciones y Contratas had liabilities of €3.65b falling due within a year, and liabilities of €6.30b due beyond that. Offsetting this, it had €1.30b in cash and €2.43b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €6.21b.

This deficit casts a shadow over the €3.95b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Fomento de Construcciones y Contratas would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

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 8.5 times its interest expense, and its net debt to EBITDA, was quite high, at 3.1. Fomento de Construcciones y Contratas grew its EBIT by 4.0% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Fomento de Construcciones y Contratas produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say Fomento de Construcciones y Contratas's level of total liabilities was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Fomento de Construcciones y Contratas's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Case in point: We've spotted 4 warning signs for Fomento de Construcciones y Contratas you should be aware of.

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.