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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Ferroglobe PLC (NASDAQ:GSM) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ferroglobe's Debt?
The image below, which you can click on for greater detail, shows that Ferroglobe had debt of US$574.1m at the end of March 2019, a reduction from US$647.0m over a year. However, it does have US$218.8m in cash offsetting this, leading to net debt of about US$355.3m.
How Healthy Is Ferroglobe's Balance Sheet?
According to the last reported balance sheet, Ferroglobe had liabilities of US$485.8m due within 12 months, and liabilities of US$742.9m due beyond 12 months. Offsetting these obligations, it had cash of US$218.8m as well as receivables valued at US$161.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$848.5m.
This deficit casts a shadow over the US$208.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Ferroglobe 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.
Even though Ferroglobe's debt is only 2.2, its interest cover is really very low at 0.87. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Importantly, Ferroglobe's EBIT fell a jaw-dropping 70% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Ferroglobe 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last two years, Ferroglobe's free cash flow amounted to 20% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Ferroglobe's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its net debt to EBITDA is not so bad. Taking into account all the aforementioned factors, it looks like Ferroglobe has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Even though Ferroglobe lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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