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Does Rio Tinto Group (LON:RIO) Have A Healthy Balance Sheet?

Simply Wall St

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. As with many other companies Rio Tinto Group (LON:RIO) 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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Rio Tinto Group

How Much Debt Does Rio Tinto Group Carry?

The chart below, which you can click on for greater detail, shows that Rio Tinto Group had US$13.0b in debt in June 2019; about the same as the year before. However, it also had US$9.62b in cash, and so its net debt is US$3.35b.

LSE:RIO Historical Debt, October 14th 2019

A Look At Rio Tinto Group's Liabilities

According to the last reported balance sheet, Rio Tinto Group had liabilities of US$11.1b due within 12 months, and liabilities of US$31.4b due beyond 12 months. On the other hand, it had cash of US$9.62b and US$3.28b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$29.6b.

Rio Tinto Group has a very large market capitalization of US$89.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Rio Tinto Group has a low net debt to EBITDA ratio of only 0.19. And its EBIT covers its interest expense a whopping 33.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Rio Tinto Group grew its EBIT at 18% 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 Rio Tinto Group'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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Rio Tinto Group recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Rio Tinto Group's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think Rio Tinto Group's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Rio Tinto Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.