Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 Fonterra Co-operative Group Limited (NZSE:FCG) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Fonterra Co-operative Group Carry?
As you can see below, Fonterra Co-operative Group had NZ$5.47b of debt at July 2020, down from NZ$6.52b a year prior. However, because it has a cash reserve of NZ$945.0m, its net debt is less, at about NZ$4.52b.
How Healthy Is Fonterra Co-operative Group’s Balance Sheet?
The latest balance sheet data shows that Fonterra Co-operative Group had liabilities of NZ$5.31b due within a year, and liabilities of NZ$5.90b falling due after that. On the other hand, it had cash of NZ$945.0m and NZ$1.82b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$8.45b.
When you consider that this deficiency exceeds the company’s NZ$6.53b 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Fonterra Co-operative Group’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Given the debt load, it’s hardly ideal that Fonterra Co-operative Group’s EBIT was pretty flat over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Fonterra Co-operative Group will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Fonterra Co-operative Group produced sturdy free cash flow equating to 78% 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.
To be frank both Fonterra Co-operative Group’s interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Fonterra Co-operative Group stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 3 warning signs for Fonterra Co-operative Group (2 make us uncomfortable!) that you should be aware of before investing here.
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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