Is Group 1 Automotive (NYSE:GPI) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Group 1 Automotive, Inc. (NYSE:GPI) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Group 1 Automotive

How Much Debt Does Group 1 Automotive Carry?

The image below, which you can click on for greater detail, shows that at September 2019 Group 1 Automotive had debt of US$2.93b, up from US$2.9k in one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Group 1 Automotive's Balance Sheet?

The latest balance sheet data shows that Group 1 Automotive had liabilities of US$2.40b due within a year, and liabilities of US$1.75b falling due after that. Offsetting these obligations, it had cash of US$41.0m as well as receivables valued at US$197.3m due within 12 months. So its liabilities total US$3.90b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$1.73b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Group 1 Automotive would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Group 1 Automotive has a rather high debt to EBITDA ratio of 6.2 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. Given the debt load, it's hardly ideal that Group 1 Automotive's EBIT was pretty flat over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Group 1 Automotive's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Group 1 Automotive recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Group 1 Automotive's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. We're quite clear that we consider Group 1 Automotive to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 2 warning signs for Group 1 Automotive (of which 1 is major) which any shareholder or potential investor should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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