Fonterra Co-operative Group (NZSE:FCG) Has A Somewhat Strained Balance Sheet

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.' 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. Importantly, Fonterra Co-operative Group Limited (NZSE:FCG) does carry debt. But the real question is whether this debt is making the company risky.

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Fonterra Co-operative Group

What Is Fonterra Co-operative Group's Debt?

As you can see below, Fonterra Co-operative Group had NZ$5.55b of debt, at January 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have NZ$319.0m in cash offsetting this, leading to net debt of about NZ$5.23b.

A Look At Fonterra Co-operative Group's Liabilities

We can see from the most recent balance sheet that Fonterra Co-operative Group had liabilities of NZ$9.82b falling due within a year, and liabilities of NZ$3.65b due beyond that. On the other hand, it had cash of NZ$319.0m and NZ$2.92b worth of receivables due within a year. So its liabilities total NZ$10.2b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the NZ$5.25b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Fonterra Co-operative Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

With a debt to EBITDA ratio of 2.1, Fonterra Co-operative Group uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.0 times its interest expenses harmonizes with that theme. Pleasingly, Fonterra Co-operative Group is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 115% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Fonterra Co-operative Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Fonterra Co-operative Group recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Fonterra Co-operative Group's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Fonterra Co-operative Group's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 Fonterra Co-operative Group you should be aware of, and 1 of them doesn't sit too well with us.

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.

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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.