Is Penske Automotive Group (NYSE:PAG) Using Too Much Debt?

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 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 the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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, 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.

Check out our latest analysis for Penske Automotive Group

What Is Penske Automotive Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Penske Automotive Group had US$4.62b of debt, an increase on US$4.03b, over one year. However, it also had US$106.5m in cash, and so its net debt is US$4.51b.

How Strong Is Penske Automotive Group's Balance Sheet?

According to the last reported balance sheet, Penske Automotive Group had liabilities of US$4.71b due within 12 months, and liabilities of US$5.23b due beyond 12 months. On the other hand, it had cash of US$106.5m and US$906.7m worth of receivables due within a year. So it has liabilities totalling US$8.93b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of US$10.0b, 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.

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.

Penske Automotive Group's net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 12.1 is very high, suggesting that the interest expense on the debt is currently quite low. We saw Penske Automotive Group grow its EBIT by 9.7% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Penske Automotive Group's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Penske Automotive Group generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Both Penske Automotive Group's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Penske Automotive Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Penske Automotive Group (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.