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 FMC Corporation (NYSE:FMC) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is FMC’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that FMC had US$3.61b of debt in March 2021, down from US$3.79b, one year before. On the flip side, it has US$424.6m in cash leading to net debt of about US$3.18b.
A Look At FMC’s Liabilities
The latest balance sheet data shows that FMC had liabilities of US$3.38b due within a year, and liabilities of US$4.01b falling due after that. Offsetting these obligations, it had cash of US$424.6m as well as receivables valued at US$2.53b due within 12 months. So its liabilities total US$4.43b more than the combination of its cash and short-term receivables.
FMC has a very large market capitalization of US$13.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt to EBITDA of 2.7 FMC has a fairly noticeable amount of debt. But the high interest coverage of 7.2 suggests it can easily service that debt. Unfortunately, FMC saw its EBIT slide 4.4% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 FMC can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, FMC recorded free cash flow of 24% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Both FMC’s conversion of EBIT to free cash flow and its EBIT growth rate were discouraging. But its not so bad at covering its interest expense with its EBIT. Looking at all the angles mentioned above, it does seem to us that FMC is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There’s no doubt that we learn most about debt from the balance sheet.