These 4 Measures Indicate That Group 1 Automotive (NYSE:GPI) 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 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. We note that Group 1 Automotive, Inc. (NYSE:GPI) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

Check out our latest analysis for Group 1 Automotive

What Is Group 1 Automotive's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Group 1 Automotive had US$3.86b of debt, an increase on US$2.90b, over one year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Group 1 Automotive's Balance Sheet?

We can see from the most recent balance sheet that Group 1 Automotive had liabilities of US$2.72b falling due within a year, and liabilities of US$3.02b due beyond that. Offsetting these obligations, it had cash of US$43.7m as well as receivables valued at US$229.8m due within 12 months. So it has liabilities totalling US$5.46b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$3.93b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Group 1 Automotive's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 5.5 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Sadly, Group 1 Automotive's EBIT actually dropped 4.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Group 1 Automotive 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Group 1 Automotive recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over Group 1 Automotive's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Group 1 Automotive's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For instance, we've identified 2 warning signs for Group 1 Automotive (1 shouldn't be ignored) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com