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

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 Rentokil Initial plc (LON:RTO) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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.

See our latest analysis for Rentokil Initial

How Much Debt Does Rentokil Initial Carry?

As you can see below, at the end of June 2023, Rentokil Initial had UK£4.32b of debt, up from UK£3.57b a year ago. Click the image for more detail. However, it does have UK£1.42b in cash offsetting this, leading to net debt of about UK£2.90b.

How Healthy Is Rentokil Initial's Balance Sheet?

We can see from the most recent balance sheet that Rentokil Initial had liabilities of UK£2.24b falling due within a year, and liabilities of UK£4.80b due beyond that. Offsetting these obligations, it had cash of UK£1.42b as well as receivables valued at UK£894.0m due within 12 months. So it has liabilities totalling UK£4.73b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Rentokil Initial has a huge market capitalization of UK£11.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Rentokil Initial's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 4.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that Rentokil Initial's EBIT shot up like bamboo after rain, gaining 61% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Rentokil Initial's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. 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 is significant) .

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.