These 4 Measures Indicate That Rentokil Initial (LON:RTO) Is Using Debt Safely

By
Simply Wall St
Published
November 17, 2021
LSE:RTO
Source: Shutterstock

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Rentokil Initial plc (LON:RTO) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Rentokil Initial

What Is Rentokil Initial's Net Debt?

As you can see below, at the end of June 2021, Rentokil Initial had UK£2.66b of debt, up from UK£1.80b a year ago. Click the image for more detail. However, it also had UK£1.73b in cash, and so its net debt is UK£924.0m.

debt-equity-history-analysis
LSE:RTO Debt to Equity History November 18th 2021

How Healthy Is Rentokil Initial's Balance Sheet?

We can see from the most recent balance sheet that Rentokil Initial had liabilities of UK£2.33b falling due within a year, and liabilities of UK£1.66b due beyond that. Offsetting this, it had UK£1.73b in cash and UK£521.8m in receivables that were due within 12 months. So it has liabilities totalling UK£1.74b more than its cash and near-term receivables, combined.

Since publicly traded Rentokil Initial shares are worth a very impressive total of UK£11.6b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Rentokil Initial's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 10.6 times, makes us even more comfortable. In addition to that, we're happy to report that Rentokil Initial has boosted its EBIT by 46%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Rentokil Initial can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Rentokil Initial actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Rentokil Initial's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Overall, we don't think Rentokil Initial is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. 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. For example, we've discovered 1 warning sign for Rentokil Initial that you should be aware of before investing here.

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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