FNM (BIT:FNM) Takes On Some Risk With Its Use Of 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that FNM S.p.A. (BIT:FNM) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

See our latest analysis for FNM

What Is FNM's Net Debt?

As you can see below, FNM had €954.7m of debt at June 2023, down from €995.4m a year prior. However, it also had €246.2m in cash, and so its net debt is €708.6m.

A Look At FNM's Liabilities

Zooming in on the latest balance sheet data, we can see that FNM had liabilities of €769.6m due within 12 months and liabilities of €929.8m due beyond that. On the other hand, it had cash of €246.2m and €468.1m worth of receivables due within a year. So it has liabilities totalling €985.2m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the €195.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, FNM would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

FNM's net debt is 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 14.8 is very high, suggesting that the interest expense on the debt is currently quite low. FNM grew its EBIT by 3.7% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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 FNM 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, FNM's free cash flow amounted to 22% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over FNM's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that FNM has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with FNM (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

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.