The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Pembina Pipeline Corporation (TSE:PPL) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Pembina Pipeline's Debt?
The chart below, which you can click on for greater detail, shows that Pembina Pipeline had CA$11.1b in debt in June 2022; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
A Look At Pembina Pipeline's Liabilities
The latest balance sheet data shows that Pembina Pipeline had liabilities of CA$3.53b due within a year, and liabilities of CA$13.4b falling due after that. On the other hand, it had cash of CA$79.0m and CA$990.0m worth of receivables due within a year. So its liabilities total CA$15.8b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of CA$23.5b, so it does suggest shareholders should keep an eye on Pembina Pipeline's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Pembina Pipeline's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 5.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Pembina Pipeline grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Pembina Pipeline's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Pembina Pipeline recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Pembina Pipeline's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at all the aforementioned factors together, it strikes us that Pembina Pipeline can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Pembina Pipeline has 2 warning signs we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.
Pembina Pipeline Corporation provides transportation and midstream services for the energy industry.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
|Analysis Area||Score (0-6)|
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Established dividend payer and fair value.