Stock Analysis

Is Rio Tinto Group (LON:RIO) Using Too Much Debt?

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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.' 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 note that Rio Tinto Group (LON:RIO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that RIO is potentially undervalued!

What Is Rio Tinto Group's Net Debt?

The image below, which you can click on for greater detail, shows that Rio Tinto Group had debt of US$11.6b at the end of June 2022, a reduction from US$12.4b over a year. However, its balance sheet shows it holds US$13.9b in cash, so it actually has US$2.33b net cash.

LSE:RIO Debt to Equity History December 1st 2022

A Look At Rio Tinto Group's Liabilities

The latest balance sheet data shows that Rio Tinto Group had liabilities of US$13.1b due within a year, and liabilities of US$31.7b falling due after that. Offsetting this, it had US$13.9b in cash and US$3.71b in receivables that were due within 12 months. So its liabilities total US$27.2b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Rio Tinto Group has a huge market capitalization of US$110.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. 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.

But the bad news is that Rio Tinto Group has seen its EBIT plunge 14% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Rio Tinto Group'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. Rio Tinto Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Rio Tinto Group produced sturdy free cash flow equating to 63% 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.

Summing Up

While Rio Tinto Group does have more liabilities than liquid assets, it also has net cash of US$2.33b. So we are not troubled with Rio Tinto Group's debt use. 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. Be aware that Rio Tinto Group is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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Find out whether Rio Tinto Group is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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