These 4 Measures Indicate That Marathon Petroleum (NYSE:MPC) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. 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.

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Marathon Petroleum

What Is Marathon Petroleum's Debt?

You can click the graphic below for the historical numbers, but it shows that Marathon Petroleum had US$24.9b of debt in December 2021, down from US$30.9b, one year before. On the flip side, it has US$10.8b in cash leading to net debt of about US$14.1b.

How Strong Is Marathon Petroleum's Balance Sheet?

We can see from the most recent balance sheet that Marathon Petroleum had liabilities of US$17.9b falling due within a year, and liabilities of US$33.9b due beyond that. On the other hand, it had cash of US$10.8b and US$11.0b worth of receivables due within a year. So its liabilities total US$29.9b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of US$43.5b, 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Marathon Petroleum's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 3.0 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. We also note that Marathon Petroleum improved its EBIT from a last year's loss to a positive US$3.8b. 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 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Marathon Petroleum produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Marathon Petroleum was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Marathon Petroleum's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 instance, we've identified 2 warning signs for Marathon Petroleum (1 makes us a bit uncomfortable) you should be aware of.

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.

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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.