Is Auto Trader Group (LON:AUTO) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Auto Trader Group plc (LON:AUTO) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Auto Trader Group

What Is Auto Trader Group's Debt?

As you can see below, at the end of March 2023, Auto Trader Group had UK£61.6m of debt, up from none a year ago. Click the image for more detail. On the flip side, it has UK£16.6m in cash leading to net debt of about UK£45.0m.

How Strong Is Auto Trader Group's Balance Sheet?

The latest balance sheet data shows that Auto Trader Group had liabilities of UK£57.9m due within a year, and liabilities of UK£77.5m falling due after that. On the other hand, it had cash of UK£16.6m and UK£68.1m worth of receivables due within a year. So it has liabilities totalling UK£50.7m 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 it's very unlikely that the UK£5.97b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Auto Trader Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Auto Trader Group's net debt is only 0.14 times its EBITDA. And its EBIT covers its interest expense a whopping 101 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Auto Trader Group grew its EBIT by 4.4% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Auto Trader Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, Auto Trader Group recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Auto Trader Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Overall, we don't think Auto Trader Group is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. Over time, share prices tend to follow earnings per share, so if you're interested in Auto Trader Group, you may well want to click here to check an interactive graph of its earnings per share history.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.