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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Par Pacific Holdings, Inc. (NYSE:PARR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

What Is Par Pacific Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Par Pacific Holdings had debt of US$639.5m, up from US$534.3m in one year. However, it does have US$228.3m in cash offsetting this, leading to net debt of about US$411.2m.

How Healthy Is Par Pacific Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Par Pacific Holdings had liabilities of US$1.45b due within 12 months and liabilities of US$1.01b due beyond that. Offsetting these obligations, it had cash of US$228.3m as well as receivables valued at US$448.5m due within 12 months. So it has liabilities totalling US$1.78b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$1.60b, we think shareholders really should watch Par Pacific Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

With net debt sitting at just 0.75 times EBITDA, Par Pacific Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.3 times the interest expense over the last year. It is just as well that Par Pacific Holdings's load is not too heavy, because its EBIT was down 49% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Par Pacific Holdings 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Par Pacific Holdings produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Par Pacific Holdings's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its conversion of EBIT to free cash flow was refreshing. Taking the abovementioned factors together we do think Par Pacific Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Par Pacific Holdings is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.

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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.