These 4 measures indicate that the BHP group (ASX: BHP) uses debt safely
Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that BHP Group (ASX: BHP) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. 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, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
See our latest analysis for the BHP group
What is the debt of the BHP group?
The image below, which you can click for more details, shows that the BHP Group had debt of $ 17.7 billion at the end of June 2021, a reduction from $ 25.2 billion US over one year. However, it has $ 15.3 billion in cash offsetting that, which leads to net debt of around $ 2.40 billion.
How healthy 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 compensation for these obligations, it had cash of US $ 15.3 billion as well as receivables valued at US $ 6.34 billion due within 12 months. Its liabilities therefore total $ 31.7 billion more than the combination of its cash and short-term receivables.
While that might sound like a lot, it’s not that big of a deal since the BHP Group has a massive market cap of US $ 134.1 billion, and so it could likely strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). 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).
With debt at 0.067 times EBITDA and an EBIT covering interest 75.0 times, it is clear that the BHP Group is not a desperate borrower. Compared to past profits, debt therefore seems insignificant. On top of that, we are happy to report that the BHP Group has increased its EBIT by 99%, reducing the specter of future debt repayments. The balance sheet is clearly the area you need to focus on when analyzing debt. 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. It is therefore worth checking to what extent this EBIT is supported by 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
The interest coverage of the BHP group suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. 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 higher return on equity. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 4 warning signs for the BHP group (1 is a little worrying!) That you should know before investing here.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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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 shares 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 the mentioned stocks.
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