Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Franco-Nevada Corporation (TSE:FNV) does have debt on its balance sheet. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Franco-Nevada's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Franco-Nevada had US$432.2m of debt, an increase on none, over one year. However, its balance sheet shows it holds US$432.3m in cash, so it actually has US$100.0k net cash.
How Strong Is Franco-Nevada's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Franco-Nevada had liabilities of US$202.0m due within 12 months and liabilities of US$356.4m due beyond that. Offsetting this, it had US$432.3m in cash and US$70.8m in receivables that were due within 12 months. So it has liabilities totalling US$55.3m more than its cash and near-term receivables, combined.
Having regard to Franco-Nevada's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$17.3b company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Franco-Nevada boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Franco-Nevada's load is not too heavy, because its EBIT was down 23% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Franco-Nevada's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Franco-Nevada 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. During the last three years, Franco-Nevada burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We could understand if investors are concerned about Franco-Nevada's liabilities, but we can be reassured by the fact it has has net cash of US$100k. So although we see some areas for improvement, we're not too worried about Franco-Nevada's balance sheet. Given our hesitation about the stock, it would be good to know if Franco-Nevada insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
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