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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Auto Trader Group plc (LON:AUTO) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Auto Trader Group's Net Debt?
The image below, which you can click on for greater detail, shows that Auto Trader Group had debt of UK£27.6m at the end of March 2021, a reduction from UK£310.5m over a year. But on the other hand it also has UK£45.7m in cash, leading to a UK£18.1m net cash position.
How Healthy Is Auto Trader Group's Balance Sheet?
We can see from the most recent balance sheet that Auto Trader Group had liabilities of UK£24.8m falling due within a year, and liabilities of UK£51.0m due beyond that. Offsetting this, it had UK£45.7m in cash and UK£57.0m in receivables that were due within 12 months. So it actually has UK£26.9m more liquid assets than total liabilities.
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£5.82b company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Auto Trader Group boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Auto Trader Group if management cannot prevent a repeat of the 38% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. 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. While Auto Trader Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Auto Trader Group generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that Auto Trader Group has net cash of UK£18.1m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of UK£123m, being 81% of its EBIT. So we don't have any problem with Auto Trader Group's use of debt. 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.
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