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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Marathon Petroleum Corporation (NYSE:MPC) does use debt in its business. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Marathon Petroleum's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Marathon Petroleum had US$26.1b of debt in March 2022, down from US$31.8b, one year before. However, it also had US$10.6b in cash, and so its net debt is US$15.5b.
How Strong Is Marathon Petroleum's Balance Sheet?
We can see from the most recent balance sheet that Marathon Petroleum had liabilities of US$25.1b falling due within a year, and liabilities of US$34.5b due beyond that. Offsetting this, it had US$10.6b in cash and US$15.7b in receivables that were due within 12 months. So it has liabilities totalling US$33.4b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its very significant market capitalization of US$43.6b, so it does suggest shareholders should keep an eye on Marathon Petroleum's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Marathon Petroleum's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 4.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, Marathon Petroleum's EBIT launched higher than Elon Musk, gaining a whopping 730% on 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 Marathon Petroleum 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Marathon Petroleum actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, Marathon Petroleum's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Marathon Petroleum can comfortably handle its current debt levels. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Marathon Petroleum has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
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.
What are the risks and opportunities for Marathon Petroleum?
Trading at 8.8% below our estimate of its fair value
Earnings grew by 1021.4% over the past year
Earnings are forecast to decline by an average of 40.8% per year for the next 3 years
Has a high level of debt
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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.