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.’ 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. Importantly, Phillips 66 (NYSE:PSX) does carry debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for Phillips 66
What Is Phillips 66’s Debt?
The image below, which you can click on for greater detail, shows that at December 2023 Phillips 66 had debt of US$19.1b, up from US$16.9b in one year. However, because it has a cash reserve of US$3.32b, its net debt is less, at about US$15.7b.
How Healthy Is Phillips 66’s Balance Sheet?
The latest balance sheet data shows that Phillips 66 had liabilities of US$15.9b due within a year, and liabilities of US$28.0b falling due after that. Offsetting this, it had US$3.32b in cash and US$11.7b in receivables that were due within 12 months. So it has liabilities totalling US$28.8b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Phillips 66 has a huge market capitalization of US$72.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
Phillips 66’s net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 13.9 times its interest expense, implies the debt load is as light as a peacock feather. But the bad news is that Phillips 66 has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Phillips 66 can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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, Phillips 66 recorded free cash flow worth a fulsome 96% 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
Both Phillips 66’s ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its EBIT growth rate had us nibbling our nails. Considering this range of data points, we think Phillips 66 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 2 warning signs for Phillips 66 you should be aware of, and 1 of them is a bit concerning.
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.
