Is Fomento de Construcciones y Contratas (BME:FCC) Using Too Much 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Fomento de Construcciones y Contratas, S.A. (BME:FCC) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Fomento de Construcciones y Contratas

How Much Debt Does Fomento de Construcciones y Contratas Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Fomento de Construcciones y Contratas had €4.99b of debt, an increase on €4.77b, over one year. However, it also had €1.56b in cash, and so its net debt is €3.43b.

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

According to the last reported balance sheet, Fomento de Construcciones y Contratas had liabilities of €4.70b due within 12 months, and liabilities of €6.05b due beyond 12 months. Offsetting this, it had €1.56b in cash and €2.87b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €6.31b.

When you consider that this deficiency exceeds the company's €5.45b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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's net debt of 2.4 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.8 times interest expense) certainly does not do anything to dispel this impression. Also relevant is that Fomento de Construcciones y Contratas has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down 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'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Fomento de Construcciones y Contratas recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Fomento de Construcciones y Contratas's ability to to grow its EBIT and its interest cover gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Fomento de Construcciones y Contratas's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For example Fomento de Construcciones y Contratas has 6 warning signs (and 1 which is significant) we think 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.