We Think BHP Group (ASX:BHP) Can Manage Its Debt With Ease

By
Simply Wall St
Published
December 26, 2021
ASX:BHP
Source: Shutterstock

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies BHP Group (ASX:BHP) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for BHP Group

How Much Debt Does BHP Group Carry?

You can click the graphic below for the historical numbers, but it shows that BHP Group had US$17.7b of debt in June 2021, down from US$25.2b, one year before. However, it does have US$15.3b in cash offsetting this, leading to net debt of about US$2.40b.

debt-equity-history-analysis
ASX:BHP Debt to Equity History December 26th 2021

How Strong Is BHP Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that BHP Group had liabilities of US$16.4b due within 12 months and liabilities of US$36.9b due beyond that. Offsetting this, it had US$15.3b in cash and US$6.34b in receivables that were due within 12 months. So it has liabilities totalling US$31.7b more than its cash and near-term receivables, combined.

BHP Group has a very large market capitalization of US$149.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

BHP Group has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.067 and EBIT of 75.0 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. On top of that, BHP Group grew its EBIT by 99% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. 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'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 we always check how much of that EBIT is translated into free cash flow. During the last three years, BHP Group produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. 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 that's just the beginning of the good news since its EBIT growth rate is also very heartening. Zooming out, BHP Group seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that BHP Group is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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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