Eagers Automotive (ASX:APE) Has A Pretty Healthy Balance Sheet

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.' 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. As with many other companies Eagers Automotive Limited (ASX:APE) makes use of debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

See our latest analysis for Eagers Automotive

What Is Eagers Automotive's Net Debt?

The image below, which you can click on for greater detail, shows that Eagers Automotive had debt of AU$1.01b at the end of December 2021, a reduction from AU$1.18b over a year. However, it also had AU$197.6m in cash, and so its net debt is AU$809.7m.

How Strong Is Eagers Automotive's Balance Sheet?

The latest balance sheet data shows that Eagers Automotive had liabilities of AU$1.34b due within a year, and liabilities of AU$1.30b falling due after that. Offsetting these obligations, it had cash of AU$197.6m as well as receivables valued at AU$264.2m due within 12 months. So it has liabilities totalling AU$2.18b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of AU$3.55b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Eagers Automotive's net debt of 1.6 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.3 times its interest expenses harmonizes with that theme. On top of that, Eagers Automotive grew its EBIT by 76% over the last twelve months, and that growth will make it easier to handle 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 Eagers 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Eagers Automotive generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Eagers Automotive's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Eagers Automotive takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Eagers Automotive has 3 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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.