Seasoned investors will know that debt is a dirty word. But what level of debt acceptable, and when is it a sign of danger?
Desperate straits
Glencore (LSE: GLEN) has, in recent months, gone from being the poster child of the past decade’s mining boom, to a cautionary tale. As the commodities supercycle that sent metal and mineral prices ever higher since the turn of the century has tailed off, tumbling prices of iron ore, aluminium and copper have meant that Glencore’s profitability has fallen through the floor. And with this, the share price has come crashing down, and is now a quarter of its all time high.
Ever since the public listing of this business in 2011, the share price has been heading downwards. The company is now worth £17.19bn. This may sound a lot, but it has a total of £19.5bn of net debt – more than its total market capitalisation. It is no wonder that Glencore has been in desperate straits over the past few months.
It is aiming to save £7bn through a capital raising, asset disposals, suspending its dividend, reducing its working capital, and several other measures. The hope is that this would bring its debt down to an acceptable, workable level. But Glencore shareholders have had a dreadful time, and I suspect any turnaround will be long and painful. I am not optimistic about this company’s future.
Investor beware
This then raises the question: could what happened to Glencore, one of the giants of the mining industry, happen to other commodity firms? What about, say, Rio Tinto (LSE: RIO)? Is this stalwart of many a pension fund also vulnerable?
Well, let’s look at the numbers. Rio Tinto’s share price has also been sliding, but in a more sedate fashion. At the current price of 2,331p, the company is worth just over £32bn — a good deal more than Glencore. How much is the net debt? It’s currently around £8.9bn — less than what I thought it would be.
So Rio Tinto’s debt/equity ratio is an eminently acceptable 27.4%. If you are a Rio Tinto shareholder, take a deep breath, and relax. The level of debt is at a manageable level. What’s more, the firm is working to bring the level of debt steadily down.
But I still think this is a case of “investor beware”. Whenever you research a company you are thinking of buying, always check the net debt, and calculate the debt to equity ratio. Anything above 30% should start to ring alarm bells.
You see, there is a lot more to a company than just a P/E ratio. It is the most common small investor mantra, and has become almost a cliché. But it bears repeating: always do your own research.