Is OPENLANE (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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies OPENLANE, Inc. (NYSE:KAR) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

View our latest analysis for OPENLANE

How Much Debt Does OPENLANE Carry?

As you can see below, OPENLANE had US$1.80b of debt at September 2024, down from US$1.94b a year prior. However, it does have US$132.1m in cash offsetting this, leading to net debt of about US$1.66b.

How Healthy Is OPENLANE's Balance Sheet?

We can see from the most recent balance sheet that OPENLANE had liabilities of US$2.59b falling due within a year, and liabilities of US$100.9m due beyond that. On the other hand, it had cash of US$132.1m and US$2.49b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$61.6m.

Given OPENLANE has a market capitalization of US$2.20b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While OPENLANE's debt to EBITDA ratio (4.7) suggests that it uses some debt, its interest cover is very weak, at 1.7, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Fortunately, OPENLANE grew its EBIT by 5.7% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if OPENLANE can strengthen its balance sheet over time. 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. Over the last three years, OPENLANE recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

While OPENLANE's conversion of EBIT to free cash flow makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. At least its level of total liabilities gives us reason to be optimistic. Taking the abovementioned factors together we do think OPENLANE's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 1 warning sign with OPENLANE , and understanding them should be part of your investment process.

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.