The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Fraser and Neave, Limited (SGX:F99) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Fraser and Neave

What Is Fraser and Neave's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Fraser and Neave had debt of S$1.11b, up from S$833.8m in one year. However, it also had S$348.1m in cash, and so its net debt is S$766.6m.

How Strong Is Fraser and Neave's Balance Sheet?

We can see from the most recent balance sheet that Fraser and Neave had liabilities of S$587.4m falling due within a year, and liabilities of S$1.11b due beyond that. On the other hand, it had cash of S$348.1m and S$379.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$973.2m.

This is a mountain of leverage relative to its market capitalization of S$1.62b. This suggests shareholders would be 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Fraser and Neave's debt is 4.1 times its EBITDA, and its EBIT cover its interest expense 4.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Fraser and Neave grew its EBIT by 2.6% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Fraser and Neave's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Fraser and Neave's free cash flow amounted to 24% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Fraser and Neave's conversion of EBIT to free cash flow makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But its not so bad at growing its EBIT. Taking the abovementioned factors together we do think Fraser and Neave's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Fraser and Neave (of which 1 is significant!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.