Does Rentokil Initial (LON:RTO) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Rentokil Initial plc (LON:RTO) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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.

Check out our latest analysis for Rentokil Initial

What Is Rentokil Initial's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Rentokil Initial had debt of UK£5.02b, up from UK£1.75b in one year. However, because it has a cash reserve of UK£2.17b, its net debt is less, at about UK£2.85b.

How Strong Is Rentokil Initial's Balance Sheet?

According to the last reported balance sheet, Rentokil Initial had liabilities of UK£2.85b due within 12 months, and liabilities of UK£4.98b due beyond 12 months. Offsetting this, it had UK£2.17b in cash and UK£868.0m in receivables that were due within 12 months. So it has liabilities totalling UK£4.79b more than its cash and near-term receivables, combined.

Rentokil Initial has a very large market capitalization of UK£15.9b, 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.

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.

Rentokil Initial's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 6.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We note that Rentokil Initial grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. 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 Rentokil Initial'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Rentokil Initial actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that Rentokil Initial's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its net debt to EBITDA has the opposite effect. Taking all this data into account, it seems to us that Rentokil Initial takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. To that end, you should learn about the 3 warning signs we've spotted with Rentokil Initial (including 1 which doesn't sit too well with us) .

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.

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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.