Is Ferrexpo (LON:FXPO) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk. 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. We can see that Ferrexpo Plc (LON:FXPO) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Ferrexpo

What Is Ferrexpo’s Net Debt?

The image below, which you can click on for greater detail, shows that Ferrexpo had debt of US$366.2m at the end of June 2019, a reduction from US$450.9m over a year. However, because it has a cash reserve of US$91.9m, its net debt is less, at about US$274.2m.

LSE:FXPO Historical Debt, November 9th 2019
LSE:FXPO Historical Debt, November 9th 2019

How Strong Is Ferrexpo’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ferrexpo had liabilities of US$227.2m due within 12 months and liabilities of US$334.2m due beyond that. Offsetting these obligations, it had cash of US$91.9m as well as receivables valued at US$161.8m due within 12 months. So it has liabilities totalling US$307.7m more than its cash and near-term receivables, combined.

This deficit isn’t so bad because Ferrexpo is worth US$965.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Ferrexpo has a low net debt to EBITDA ratio of only 0.43. And its EBIT covers its interest expense a whopping 22.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Ferrexpo has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ferrexpo 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Ferrexpo’s free cash flow amounted to 50% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Ferrexpo’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Taking all this data into account, it seems to us that Ferrexpo takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We’d be motivated to research the stock further if we found out that Ferrexpo insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.

Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.