Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies Pembina Pipeline Company (TSE:PPL) uses debt. But does this debt worry shareholders?
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
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How much debt does Pembina Pipeline have?
The graph below, which you can click on for more details, shows that Pembina Pipeline had C$11.1 billion in debt as of June 2022; about the same as the previous year. And he doesn’t have a lot of cash, so his net debt is about the same.
A Look at Pembina Pipeline Liabilities
The latest balance sheet data shows Pembina Pipeline had C$3.53 billion in liabilities due within one year, and C$13.4 billion in liabilities falling due thereafter. On the other hand, it had liquid assets of 79.0 million Canadian dollars and 990.0 million Canadian dollars of receivables at less than one year. Thus, its liabilities total C$15.8 billion more than the combination of its cash and short-term receivables.
This deficit is considerable compared to its very large market capitalization of 23.5 billion Canadian dollars. He therefore suggests that shareholders monitor the use of debt by Pembina Pipeline. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Pembina Pipeline’s debt is 3.7 times its EBITDA, and its EBT covers its interest expense 5.4 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. Importantly, Pembina Pipeline has grown its EBIT by 33% over the past twelve months, and this growth will help manage its debt. There is no doubt that we learn the most about debt from the balance sheet. But future earnings, more than anything, will determine Pembina Pipeline’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Pembina Pipeline has recorded free cash flow equivalent to 76% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is that Pembina Pipeline’s proven ability to increase EBIT delights us like a sweet puppy does a toddler. But, on a darker note, we’re a bit concerned about its net debt to EBITDA. Looking at all of the above factors together, it seems to us that Pembina Pipeline can manage its debt quite comfortably. On the plus side, this leverage can increase shareholder returns, but the potential downside is more risk of loss, so it’s worth keeping an eye on the balance sheet. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example – Pembina Pipeline has 2 warning signs we think you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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