Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Fox Company (NASDAQ:FOXA) uses debt in its business. But does this debt worry shareholders?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What is Fox’s debt?
As you can see below, Fox had $7.95 billion in debt, as of September 2021, which is about the same as the year before. You can click on the graph for more details. However, he has $5.41 billion in cash to offset this, resulting in a net debt of approximately $2.54 billion.
How strong is Fox’s balance sheet?
The latest balance sheet data shows Fox had $2.87 billion in liabilities due within the year, and $8.56 billion in liabilities due thereafter. In return, he had $5.41 billion in cash and $2.19 billion in receivables due within 12 months. Thus, its liabilities total $3.83 billion more than the combination of its cash and short-term receivables.
Given that Fox has a colossal market cap of US$22.0 billion, it’s hard to believe that these liabilities pose much of a threat. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
While Fox’s low debt-to-EBITDA ratio of 0.85 suggests only modest debt usage, the fact that EBIT only covered interest expense by 6.8 times last year makes us reflect. But the interest payments are certainly enough to make us think about the affordability of its debt. But the flip side is that Fox has seen its EBIT drop 5.0% over the past year. This type of decline, if it continues, will obviously make the debt more difficult to manage. There is no doubt that we learn the most about debt from the balance sheet. But it’s future earnings, more than anything, that will determine Fox’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future, you can check out this free report showing analyst earnings forecasts.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Fox has had free cash flow of 78% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Fortunately, Fox’s impressive EBIT to free cash flow conversion means it has the upper hand on its debt. But, on a darker note, we are a bit concerned about its EBIT growth rate. All told, it looks like Fox can comfortably handle its current level of debt. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. We have identified 1 warning sign with the fox and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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