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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Fincantieri S.p.A. (BIT:FCT) does carry 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.
What Is Fincantieri's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Fincantieri had debt of €2.32b, up from €1.78b in one year. On the flip side, it has €683.5m in cash leading to net debt of about €1.64b.
How Strong Is Fincantieri's Balance Sheet?
The latest balance sheet data shows that Fincantieri had liabilities of €4.70b due within a year, and liabilities of €1.05b falling due after that. Offsetting this, it had €683.5m in cash and €3.32b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.76b.
Given this deficit is actually higher than the company's market capitalization of €1.47b, we think shareholders really should watch Fincantieri's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Fincantieri's debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 3.5 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a slightly more positive note, Fincantieri grew its EBIT at 11% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Fincantieri'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Fincantieri produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While Fincantieri's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Fincantieri is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in Fincantieri, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.