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. 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. As with many other companies Asbury Automotive Group, Inc. (NYSE:ABG) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Asbury Automotive Group Carry?
You can click the graphic below for the historical numbers, but it shows that Asbury Automotive Group had US$1.84b of debt in September 2019, down from US$1.96b, one year before. Net debt is about the same, since the it doesn’t have much cash.
A Look At Asbury Automotive Group’s Liabilities
We can see from the most recent balance sheet that Asbury Automotive Group had liabilities of US$1.24b falling due within a year, and liabilities of US$981.4m due beyond that. Offsetting these obligations, it had cash of US$1.80m as well as receivables valued at US$112.5m due within 12 months. So it has liabilities totalling US$2.10b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$1.85b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 5.0, it’s fair to say Asbury Automotive Group does have a significant amount of debt. However, its interest coverage of 3.6 is reasonably strong, which is a good sign. The good news is that Asbury Automotive Group improved its EBIT by 5.5% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Asbury Automotive Group 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Asbury Automotive Group’s free cash flow amounted to 42% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Asbury Automotive Group’s level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Overall, we think it’s fair to say that Asbury Automotive Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 2 warning signs for Asbury Automotive Group you should be aware of, and 1 of them is concerning.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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