Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Auto Trader Group plc (LON:AUTO) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Auto Trader Group's Debt?
The image below, which you can click on for greater detail, shows that Auto Trader Group had debt of UK£86.8m at the end of September 2020, a reduction from UK£325.7m over a year. On the flip side, it has UK£31.4m in cash leading to net debt of about UK£55.4m.
How Strong Is Auto Trader Group's Balance Sheet?
According to the last reported balance sheet, Auto Trader Group had liabilities of UK£31.5m due within 12 months, and liabilities of UK£115.1m due beyond 12 months. Offsetting these obligations, it had cash of UK£31.4m as well as receivables valued at UK£59.9m due within 12 months. So it has liabilities totalling UK£55.3m more than its cash and near-term receivables, combined.
This state of affairs indicates that Auto Trader Group's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the UK£5.72b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Auto Trader Group has a very light debt load indeed.
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).
Auto Trader Group's net debt is only 0.28 times its EBITDA. And its EBIT easily covers its interest expense, being 32.3 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Auto Trader Group if management cannot prevent a repeat of the 23% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Auto Trader Group'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, 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. Over the last three years, Auto Trader Group recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
The good news is that Auto Trader Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. Taking all this data into account, it seems to us that Auto Trader Group takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. For instance, we've identified 1 warning sign for Auto Trader Group that you 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.
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