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.’ 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. We note that America’s Car-Mart, Inc. (NASDAQ:CRMT) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is America’s Car-Mart’s Debt?
The chart below, which you can click on for greater detail, shows that America’s Car-Mart had US$153.4m in debt in April 2019; about the same as the year before. And it doesn’t have much cash, so its net debt is about the same.
How Strong Is America’s Car-Mart’s Balance Sheet?
We can see from the most recent balance sheet that America’s Car-Mart had liabilities of US$32.9m falling due within a year, and liabilities of US$198.7m due beyond that. On the other hand, it had cash of US$1.75m and US$419.8m worth of receivables due within a year. So it can boast US$189.9m more liquid assets than total liabilities.
This surplus liquidity suggests that America’s Car-Mart’s balance sheet could take a hit just as well as Homer Simpson’s head can take a punch. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino.
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).
With a debt to EBITDA ratio of 2.1, America’s Car-Mart uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.6 times interest expense) certainly does not do anything to dispel this impression. It is well worth noting that America’s Car-Mart’s EBIT shot up like bamboo after rain, gaining 52% in the last twelve months. That’ll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine America’s Car-Mart’s ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, America’s Car-Mart’s free cash flow amounted to 23% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
The good news is that America’s Car-Mart’s demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at the bigger picture, we think America’s Car-Mart’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that America’s Car-Mart insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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