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. As with many other companies Phillips 66 (NYSE:PSX) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Phillips 66’s Debt?
You can click the graphic below for the historical numbers, but it shows that Phillips 66 had US$14.4b of debt in March 2022, down from US$15.4b, one year before. On the flip side, it has US$3.34b in cash leading to net debt of about US$11.1b.
How Healthy Is Phillips 66’s Balance Sheet?
We can see from the most recent balance sheet that Phillips 66 had liabilities of US$17.6b falling due within a year, and liabilities of US$20.9b due beyond that. On the other hand, it had cash of US$3.34b and US$10.5b worth of receivables due within a year. So its liabilities total US$24.7b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Phillips 66 is worth a massive US$43.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Phillips 66’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. One redeeming factor for Phillips 66 is that it turned last year’s EBIT loss into a gain of US$1.6b, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Phillips 66 can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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. Happily for any shareholders, Phillips 66 actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
When it comes to the balance sheet, the standout positive for Phillips 66 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. When we consider all the factors mentioned above, we do feel a bit cautious about Phillips 66’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start.