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.' 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. We can see that O'Reilly Automotive, Inc. (NASDAQ:ORLY) does use debt in its business. 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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is O'Reilly Automotive's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 O'Reilly Automotive had US$4.62b of debt, an increase on US$3.70b, over one year. However, because it has a cash reserve of US$1.63b, its net debt is less, at about US$3.00b.
How Healthy Is O'Reilly Automotive's Balance Sheet?
According to the last reported balance sheet, O'Reilly Automotive had liabilities of US$5.67b due within 12 months, and liabilities of US$6.13b due beyond 12 months. On the other hand, it had cash of US$1.63b and US$333.5m worth of receivables due within a year. So its liabilities total US$9.83b more than the combination of its cash and short-term receivables.
O'Reilly Automotive has a very large market capitalization of US$32.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
O'Reilly Automotive has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 15.0 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, O'Reilly Automotive grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 O'Reilly Automotive'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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, O'Reilly Automotive produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
O'Reilly Automotive's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think O'Reilly Automotive's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Take risks, for example - O'Reilly Automotive has 2 warning signs we think you should be aware of.
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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