These 4 Measures Indicate That BHP Group (ASX:BHP) Is Using Debt Safely

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.' 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. Importantly, BHP Group Limited (ASX:BHP) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for BHP Group

What Is BHP Group's Net Debt?

As you can see below, BHP Group had US$16.8b of debt at December 2021, down from US$19.8b a year prior. However, it also had US$12.6b in cash, and so its net debt is US$4.25b.

A Look At BHP Group's Liabilities

Zooming in on the latest balance sheet data, we can see that BHP Group had liabilities of US$20.6b due within 12 months and liabilities of US$30.2b due beyond that. Offsetting this, it had US$12.6b in cash and US$5.14b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$33.1b.

Since publicly traded BHP Group shares are worth a very impressive total of US$198.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

BHP Group has a low net debt to EBITDA ratio of only 0.11. And its EBIT covers its interest expense a whopping 85.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that BHP Group has boosted its EBIT by 94%, thus reducing the spectre of future debt repayments. 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 BHP Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, BHP Group recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, BHP Group's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that BHP Group is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example BHP Group has 2 warning signs (and 1 which is significant) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.