We Think Fomento de Construcciones y Contratas (BME:FCC) Is Taking Some Risk With Its Debt

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. We can see that Fomento de Construcciones y Contratas, S.A. (BME:FCC) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Fomento de Construcciones y Contratas

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

As you can see below, Fomento de Construcciones y Contratas had €4.15b of debt at March 2021, down from €5.06b a year prior. On the flip side, it has €1.53b in cash leading to net debt of about €2.61b.

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 €3.11b due within 12 months, and liabilities of €5.57b due beyond 12 months. Offsetting these obligations, it had cash of €1.53b as well as receivables valued at €2.20b due within 12 months. So its liabilities total €4.95b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's €4.30b 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). 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 a debt to EBITDA ratio of 2.5 and its EBIT covered its interest expense 5.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. If Fomento de Construcciones y Contratas can keep growing EBIT at last year's rate of 11% 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 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 always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Fomento de Construcciones y Contratas recorded free cash flow of 45% of its EBIT, which is weaker 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. For example, its EBIT growth rate is relatively strong. Taking the abovementioned factors together we do think Fomento de Construcciones y Contratas's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 3 warning signs we've spotted with Fomento de Construcciones y Contratas (including 1 which can't be ignored) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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.
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