These 4 Measures Indicate That KAR Auction Services (NYSE:KAR) Is Using Debt Extensively

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.' 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 KAR Auction Services, Inc. (NYSE:KAR) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for KAR Auction Services

What Is KAR Auction Services's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2021 KAR Auction Services had debt of US$3.22b, up from US$2.65b in one year. However, it also had US$621.6m in cash, and so its net debt is US$2.59b.

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$2.68b falling due within a year, and liabilities of US$2.36b due beyond that. On the other hand, it had cash of US$621.6m and US$2.63b worth of receivables due within a year. So its liabilities total US$1.79b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$1.81b, so it does suggest shareholders should keep an eye on KAR Auction Services' use of debt. 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). 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 (6.1), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. The debt burden here is substantial. However, one redeeming factor is that KAR Auction Services grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine KAR Auction Services'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 the logical step is to look at the proportion of that EBIT that is matched by actual 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

KAR Auction Services's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that KAR Auction Services is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for KAR Auction Services you should know about.

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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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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