How Safe Is Your Money In Rio Tinto plc?

Iron ore giant Rio Tinto (LSE: RIO) (NYSE: RIO.US) bounced back to profit in 2013, but its share price performance hasn’t followed. After peaking at 3,680p in February, fears of a Chinese slowdown have driven Rio’s share price down to 3,175p — nearly 5% lower than twelve months ago.

High levels of share price volatility are quite common with mining companies, and don’t always indicate that the company itself is on precarious footing. In Rio’s case, I don’t think there is much to worry about, but to make sure, I’ve taken a closer look at three key financial ratios which should highlight any weakness in the firm’s underlying business.

1. Operating profit/interest

What we’re looking for here is a ratio of at least 1.5, preferably over 2, to show that Rio’s earnings cover its interest payments, with room to spare:

Operating profit / net interest paid

$7,430m / $1,164m = 6.4 times cover

Rio’s interest cover looks pretty safe, and allows plenty of headroom for a fall in the price of iron ore, which accounts for around 80% of the mining giant’s earnings.

Rio’s gross profit margin on iron ore is around 65%, enabling it to remain profitable at much lower prices than at present, but any sustained drop in the price of iron ore would impact the miner’s profits, as its interest payments would remain fixed.

2. Debt/equity ratio

Commonly referred to as gearing, this is simply the ratio of debt to shareholder equity, or book value. I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.

rio tintoAt the end of 2013, Rio’s net debt was $18.4bn and its book value was $53.5bn, giving net gearing of 34%. I’m comfortable with this, although I’d like to see further reductions over the coming year, to strengthen the firm’s ability to cope with weaker commodity prices.

3. Operating profit/sales

This ratio is usually known as operating margin and is useful measure of a company’s profitability.

Rio’s operating margin of 14.5% is lower than the 23% average it achieved during the 2008-2011 mining boom, but is attractive, and may rise this year as Rio’s giant Oyu Tolgoi copper-gold mine in Mongolia makes a larger contribution to the firm’s earnings.

Is Rio a safe bet?

I’m comfortable with Rio’s finances, and as a shareholder, I’m happy to ignore the miner’s volatile share price and simply sit back and collect my dividends (the payout is forecast to rise to 3.9% this year).

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Roland owns shares Rio Tinto.