Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Motorcar Parts of America, Inc. (NASDAQ:MPAA) does carry debt. But the real question is whether this debt is making the company risky.
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.
What Is Motorcar Parts of America's Debt?
The image below, which you can click on for greater detail, shows that Motorcar Parts of America had debt of US$116.3m at the end of September 2020, a reduction from US$170.0m over a year. However, because it has a cash reserve of US$22.1m, its net debt is less, at about US$94.2m.
How Healthy Is Motorcar Parts of America's Balance Sheet?
The latest balance sheet data shows that Motorcar Parts of America had liabilities of US$302.8m due within a year, and liabilities of US$188.6m falling due after that. Offsetting this, it had US$22.1m in cash and US$124.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$344.9m.
This is a mountain of leverage relative to its market capitalization of US$401.6m. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Motorcar Parts of America's net debt to EBITDA ratio of 2.9, we think its super-low interest cover of 1.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. More concerning, Motorcar Parts of America saw its EBIT drop by 4.0% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Motorcar Parts of America'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. During the last three years, Motorcar Parts of America burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Motorcar Parts of America's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. We're quite clear that we consider Motorcar Parts of America to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Motorcar Parts of America is showing 4 warning signs in our investment analysis , and 1 of those is concerning...
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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