These 4 Measures Indicate That Fonterra Co-operative Group (NZSE:FCG) Is Using Debt Extensively

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 note that Fonterra Co-operative Group Limited (NZSE:FCG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Fonterra Co-operative Group

What Is Fonterra Co-operative Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of July 2022 Fonterra Co-operative Group had NZ$4.85b of debt, an increase on NZ$4.57b, over one year. However, it does have NZ$288.0m in cash offsetting this, leading to net debt of about NZ$4.56b.

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$6.52b falling due within a year, and liabilities of NZ$5.36b due beyond that. Offsetting these obligations, it had cash of NZ$288.0m as well as receivables valued at NZ$2.48b due within 12 months. So it has liabilities totalling NZ$9.11b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the NZ$4.19b company, like a colossus towering over mere mortals. 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Fonterra Co-operative Group has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 6.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. It is well worth noting that Fonterra Co-operative Group's EBIT shot up like bamboo after rain, gaining 44% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Fonterra Co-operative Group will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Fonterra Co-operative Group recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Fonterra Co-operative Group's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Fonterra Co-operative Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example Fonterra Co-operative Group has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.