Is Penske Automotive Group (NYSE:PAG) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Penske Automotive Group, Inc. (NYSE:PAG) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Penske Automotive Group

What Is Penske Automotive Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Penske Automotive Group had US$4.60b of debt, an increase on US$4.01b, over one year. However, it does have US$100.6m in cash offsetting this, leading to net debt of about US$4.50b.

How Strong Is Penske Automotive Group's Balance Sheet?

The latest balance sheet data shows that Penske Automotive Group had liabilities of US$4.76b due within a year, and liabilities of US$5.28b falling due after that. On the other hand, it had cash of US$100.6m and US$920.2m worth of receivables due within a year. So it has liabilities totalling US$9.02b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of US$10.8b, so it does suggest shareholders should keep an eye on Penske Automotive Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

With net debt to EBITDA of 2.8 Penske Automotive Group has a fairly noticeable amount of debt. But the high interest coverage of 9.9 suggests it can easily service that debt. Sadly, Penske Automotive Group's EBIT actually dropped 5.2% 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 Penske Automotive Group 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Penske Automotive Group generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

On our analysis Penske Automotive Group's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Penske Automotive Group's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Penske Automotive Group (of which 1 makes us a bit uncomfortable!) you should know about.

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.

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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.