These 4 Measures Indicate That CAR Group (ASX:CAR) Is Using Debt Safely

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that CAR Group Limited (ASX:CAR) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for CAR Group

How Much Debt Does CAR Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 CAR Group had AU$1.30b of debt, an increase on AU$1.17b, over one year. On the flip side, it has AU$309.6m in cash leading to net debt of about AU$988.3m.

How Healthy Is CAR Group's Balance Sheet?

The latest balance sheet data shows that CAR Group had liabilities of AU$243.0m due within a year, and liabilities of AU$1.49b falling due after that. Offsetting these obligations, it had cash of AU$309.6m as well as receivables valued at AU$145.2m due within 12 months. So its liabilities total AU$1.28b more than the combination of its cash and short-term receivables.

Of course, CAR Group has a market capitalization of AU$14.4b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

CAR Group has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.3 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, CAR Group grew its EBIT by 41% over the last twelve months, and that growth will make it easier to handle its debt. 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 CAR Group'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, CAR Group produced sturdy free cash flow equating to 78% 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

The good news is that CAR Group's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, CAR Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for CAR Group you should know about.

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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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.