Seasoned investors will know that debt isa dirty word. But what level ofdebt acceptable, and when is it a sign of danger?
Glencore (LSE: GLEN) has, inrecent months, gone from being the posterchild of the past decades mining boom, toa 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 Glencores 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, workablelevel. But Glencore shareholders have had a dreadful time, and I suspect any turnaround will be long and painful. I am not optimistic about this companys future.
This then raises the question:could what happenedto 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, lets look at the numbers. Rio Tintos 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? Its currently around 8.9bn less than what I thought it would be.
So Rio Tintosdebt/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 amanageable level. Whats 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 clich. But it bears repeating: always do your own research.
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Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.