These 4 Measures Indicate That Pembina Pipeline (TSE:PPL) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Pembina Pipeline Corporation (TSE:PPL) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Pembina Pipeline

What Is Pembina Pipeline's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Pembina Pipeline had CA$12.8b of debt, an increase on CA$10.6b, over one year. And it doesn't have much cash, so its net debt is about the same.

A Look At Pembina Pipeline's Liabilities

According to the last reported balance sheet, Pembina Pipeline had liabilities of CA$2.37b due within 12 months, and liabilities of CA$15.9b due beyond 12 months. On the other hand, it had cash of CA$256.0m and CA$1.03b worth of receivables due within a year. So its liabilities total CA$17.0b more than the combination of its cash and short-term receivables.

Pembina Pipeline has a very large market capitalization of CA$30.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Pembina Pipeline has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 4.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way Pembina Pipeline could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Pembina Pipeline can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Pembina Pipeline recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

When it comes to the balance sheet, the standout positive for Pembina Pipeline was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. Considering this range of data points, we think Pembina Pipeline is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Pembina Pipeline you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.