Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Rentokil Initial plc (LON:RTO) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Rentokil Initial's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Rentokil Initial had debt of UK£1.65b, up from UK£1.25b in one year. On the flip side, it has UK£452.4m in cash leading to net debt of about UK£1.20b.
How Strong Is Rentokil Initial's Balance Sheet?
According to the last reported balance sheet, Rentokil Initial had liabilities of UK£1.36b due within 12 months, and liabilities of UK£1.53b due beyond 12 months. Offsetting these obligations, it had cash of UK£452.4m as well as receivables valued at UK£552.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.89b.
Rentokil Initial has a very large market capitalization of UK£8.34b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Rentokil Initial has a debt to EBITDA ratio of 2.5 and its EBIT covered its interest expense 5.8 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Rentokil Initial grew its EBIT by 3.4% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Rentokil Initial 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Rentokil Initial produced sturdy free cash flow equating to 67% 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.
When it comes to the balance sheet, the standout positive for Rentokil Initial was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. When we consider all the elements mentioned above, it seems to us that Rentokil Initial is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. While Rentokil Initial didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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