Is KAR Auction Services (NYSE:KAR) 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. We note that KAR Auction Services, Inc. (NYSE:KAR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for KAR Auction Services

What Is KAR Auction Services's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 KAR Auction Services had US$3.57b of debt, an increase on US$3.17b, over one year. On the flip side, it has US$190.0m in cash leading to net debt of about US$3.38b.

How Healthy Is KAR Auction Services' Balance Sheet?

We can see from the most recent balance sheet that KAR Auction Services had liabilities of US$2.98b falling due within a year, and liabilities of US$2.34b due beyond that. On the other hand, it had cash of US$190.0m and US$3.03b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.09b.

This is a mountain of leverage relative to its market capitalization of US$2.14b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

KAR Auction Services shareholders face the double whammy of a high net debt to EBITDA ratio (8.7), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that KAR Auction Services grew its EBIT a smooth 36% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if KAR Auction Services 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, KAR Auction Services actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We weren't impressed with KAR Auction Services's interest cover, and its net debt to EBITDA made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. Looking at all this data makes us feel a little cautious about KAR Auction Services's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should learn about the 2 warning signs we've spotted with KAR Auction Services (including 1 which doesn't sit too well with us) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.