Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. We note that Marathon Petroleum Corporation (NYSE:MPC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Marathon Petroleum
What Is Marathon Petroleum’s Debt?
As you can see below, Marathon Petroleum had US$26.2b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$11.1b in cash offsetting this, leading to net debt of about US$15.0b.
How Healthy Is Marathon Petroleum’s Balance Sheet?
We can see from the most recent balance sheet that Marathon Petroleum had liabilities of US$21.3b falling due within a year, and liabilities of US$34.6b due beyond that. Offsetting this, it had US$11.1b in cash and US$13.5b in receivables that were due within 12 months. So its liabilities total US$31.3b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Marathon Petroleum is worth a massive US$56.4b, and thus could probably raise enough capital to shore up 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.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Marathon Petroleum has a low net debt to EBITDA ratio of only 0.75. And its EBIT easily covers its interest expense, being 15.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Marathon Petroleum grew its EBIT by 565% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Marathon Petroleum can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last two years, Marathon Petroleum produced sturdy free cash flow equating to 73% 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.
Our View
Marathon Petroleum’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at the bigger picture, we think Marathon Petroleum’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 2 warning signs for Marathon Petroleum you should be aware of, and 1 of them makes us a bit uncomfortable.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
Valuation is complex, but we’re helping make it simple.
Find out whether Marathon Petroleum is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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