We Think Group 1 Automotive (NYSE:GPI) Is Taking Some Risk With Its Debt

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.' 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.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Group 1 Automotive

What Is Group 1 Automotive's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Group 1 Automotive had US$3.09b of debt, an increase on US$2.51b, over one year. Net debt is about the same, since the it doesn't have much cash.

A Look At Group 1 Automotive's Liabilities

The latest balance sheet data shows that Group 1 Automotive had liabilities of US$2.17b due within a year, and liabilities of US$2.65b falling due after that. Offsetting these obligations, it had cash of US$53.3m as well as receivables valued at US$194.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.58b.

When you consider that this deficiency exceeds the company's US$3.73b 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.

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

Group 1 Automotive's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 6.9 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 6.2% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Group 1 Automotive produced sturdy free cash flow equating to 67% 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.

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. Once we consider all the factors above, together, it seems to us that Group 1 Automotive's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 2 warning signs for Group 1 Automotive you should be aware of.

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.