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These 4 Measures Indicate That Fonterra Co-operative Group (NZSE:FCG) Is Using Debt In A Risky Way

Simply Wall St

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. As with many other companies Fonterra Co-operative Group Limited (NZSE:FCG) makes use of debt. But the more important question is: how much risk is that debt creating?

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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Fonterra Co-operative Group

What Is Fonterra Co-operative Group's Net Debt?

The chart below, which you can click on for greater detail, shows that Fonterra Co-operative Group had NZ$7.68b in debt in January 2019; about the same as the year before. However, it does have NZ$348.0m in cash offsetting this, leading to net debt of about NZ$7.33b.

NZSE:FCG Historical Debt, August 12th 2019

How Strong Is Fonterra Co-operative Group's Balance Sheet?

The latest balance sheet data shows that Fonterra Co-operative Group had liabilities of NZ$5.76b due within a year, and liabilities of NZ$7.80b falling due after that. On the other hand, it had cash of NZ$348.0m and NZ$2.28b worth of receivables due within a year. So it has liabilities totalling NZ$10.9b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the NZ$6.06b 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 definitely think shareholders need to watch this one closely. After all, Fonterra Co-operative Group would likely require a major re-capitalisation if it had to pay its creditors today.

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

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 6.4 hit our confidence in Fonterra Co-operative Group like a one-two punch to the gut. The debt burden here is substantial. Even worse, Fonterra Co-operative Group saw its EBIT tank 27% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Fonterra Co-operative Group produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Fonterra Co-operative Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Fonterra Co-operative Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Fonterra Co-operative Group's earnings per share history for free.

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.

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.