Is Fomento de Construcciones y Contratas (BME:FCC) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Fomento de Construcciones y Contratas, S.A. (BME:FCC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Fomento de Construcciones y Contratas

What Is Fomento de Construcciones y Contratas's Net Debt?

The chart below, which you can click on for greater detail, shows that Fomento de Construcciones y Contratas had €4.93b in debt in December 2023; about the same as the year before. However, it does have €1.80b in cash offsetting this, leading to net debt of about €3.13b.

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 €3.86b falling due within a year, and liabilities of €6.71b due beyond that. Offsetting these obligations, it had cash of €1.80b as well as receivables valued at €2.88b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €5.88b.

Given this deficit is actually higher than the company's market capitalization of €5.84b, we think shareholders really should watch Fomento de Construcciones y Contratas's debt levels, like a parent watching their child ride a bike for the first time. 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.

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.

With a debt to EBITDA ratio of 2.1, Fomento de Construcciones y Contratas uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.0 times interest expense) certainly does not do anything to dispel this impression. We note that Fomento de Construcciones y Contratas grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into 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 free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither Fomento de Construcciones y Contratas's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. 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. 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 2 warning signs for Fomento de Construcciones y Contratas you should be aware of, and 1 of them is a bit unpleasant.

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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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.