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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. As with many other companies FNM S.p.A. (BIT:FNM) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
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How Much Debt Does FNM Carry?
The image below, which you can click on for greater detail, shows that FNM had debt of €264.9m at the end of June 2019, a reduction from €282.2m over a year. However, because it has a cash reserve of €183.4m, its net debt is less, at about €81.5m.
How Healthy Is FNM's Balance Sheet?
According to the last reported balance sheet, FNM had liabilities of €305.8m due within 12 months, and liabilities of €218.5m due beyond 12 months. Offsetting these obligations, it had cash of €183.4m as well as receivables valued at €181.9m due within 12 months. So it has liabilities totalling €159.1m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of €230.1m, so it does suggest shareholders should keep an eye on FNM's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.