Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Like many other companies BHP Group (ASX: BHP) uses debt. But the most important question is: what risk does this debt create?
When is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth without negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest analysis for the BHP group
What is the debt of the BHP group?
You can click on the graph below for historical figures, but it shows that the BHP Group had $ 17.7 billion in debt in June 2021, down from $ 25.2 billion a year earlier. However, it has $ 15.3 billion in cash offsetting that, which leads to net debt of around $ 2.40 billion.
How strong is the balance sheet of the BHP group?
Zooming in on the latest balance sheet data, we can see that the BHP Group had liabilities of US $ 16.4 billion due within 12 months and US $ 36.9 billion liabilities beyond. In return, he had $ 15.3 billion in cash and $ 6.34 billion in receivables due within 12 months. It therefore has liabilities totaling $ 31.7 billion more than its cash and short-term receivables combined.
BHP Group has a very large market capitalization of US $ 149.7 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
The BHP group has very little debt (net of cash) and has a debt / EBITDA ratio of 0.067 and an EBIT of 75.0 times the interest expense. Indeed, compared to his income, his debt seems light as a feather. On top of that, BHP Group has increased its EBIT by 99% over the past twelve months, and this growth will make it easier to process its debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine the ability of the BHP Group to maintain a healthy balance sheet in the future. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, the BHP Group has generated strong free cash flow equivalent to 64% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Fortunately, BHP Group’s impressive interest coverage means it has the upper hand over its debt. And that’s just the start of good news as its EBIT growth rate is also very encouraging. When zoomed out, the BHP group appears to be using debt quite sensibly; and that gets the nod from us. While debt comes with risk, when used wisely, it can also generate a better return on equity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. Note that BHP Group displays 2 warning signs in our investment analysis , and 1 of them doesn’t go too well with us …
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.