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Is Fortescue Metals Group (ASX:FMG) Using Too Much Debt?

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. We can see that Fortescue Metals Group Limited (ASX:FMG) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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.

Check out our latest analysis for Fortescue Metals Group

What Is Fortescue Metals Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Fortescue Metals Group had US$3.20b of debt in December 2019, down from US$3.39b, one year before. However, it does have US$3.31b in cash offsetting this, leading to net cash of US$110.0m.

ASX:FMG Historical Debt June 17th 2020

A Look At Fortescue Metals Group's Liabilities

The latest balance sheet data shows that Fortescue Metals Group had liabilities of US$2.41b due within a year, and liabilities of US$6.37b falling due after that. Offsetting these obligations, it had cash of US$3.31b as well as receivables valued at US$474.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.99b.

Given Fortescue Metals Group has a humongous market capitalization of US$31.5b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Fortescue Metals Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that Fortescue Metals Group grew its EBIT by 328% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Fortescue Metals Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Fortescue Metals Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Fortescue Metals Group recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While Fortescue Metals Group does have more liabilities than liquid assets, it also has net cash of US$110.0m. And it impressed us with its EBIT growth of 328% over the last year. So we don't think Fortescue Metals Group's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Fortescue Metals Group (1 is a bit unpleasant) you should be aware of.

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. 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. Thank you for reading.