Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 carsales.com Ltd (ASX:CAR) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does carsales.com Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 carsales.com had AU$527.1m of debt, an increase on AU$206.6m, over one year. However, because it has a cash reserve of AU$108.1m, its net debt is less, at about AU$419.0m.
How Healthy Is carsales.com’s Balance Sheet?
We can see from the most recent balance sheet that carsales.com had liabilities of AU$65.1m falling due within a year, and liabilities of AU$569.3m due beyond that. Offsetting these obligations, it had cash of AU$108.1m as well as receivables valued at AU$58.8m due within 12 months. So its liabilities total AU$467.5m more than the combination of its cash and short-term receivables.
Given carsales.com has a market capitalization of AU$3.63b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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).
carsales.com’s net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 14.2 times, makes us even more comfortable. carsales.com grew its EBIT by 8.3% in the last year. That’s far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if carsales.com 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, carsales.com recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, carsales.com’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like carsales.com is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We’d be motivated to research the stock further if we found out that carsales.com insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.