Is Rio Tinto Group (LON:RIO) A Risky Investment?

By
Simply Wall St
Published
June 01, 2021
LSE:RIO
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.' 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. We note that Rio Tinto Group (LON:RIO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Rio Tinto Group

How Much Debt Does Rio Tinto Group Carry?

As you can see below, Rio Tinto Group had US$12.7b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$13.1b in cash offsetting this, leading to net cash of US$405.0m.

debt-equity-history-analysis
LSE:RIO Debt to Equity History June 2nd 2021

How Strong Is Rio Tinto Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rio Tinto Group had liabilities of US$11.6b due within 12 months and liabilities of US$33.9b due beyond that. On the other hand, it had cash of US$13.1b and US$3.44b worth of receivables due within a year. So it has liabilities totalling US$29.0b more than its cash and near-term receivables, combined.

Of course, Rio Tinto Group has a titanic market capitalization of US$147.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Rio Tinto Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

Another good sign is that Rio Tinto Group has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Rio Tinto Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Rio Tinto Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Rio Tinto Group recorded free cash flow worth 60% 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.

Summing up

Although Rio Tinto Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$405.0m. And it impressed us with its EBIT growth of 26% over the last year. So is Rio Tinto Group's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Rio Tinto Group (at least 1 which is significant) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. 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.
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