Penske Automotive Group (NYSE:PAG) Seems To Use Debt Quite Sensibly

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. We can see that Penske Automotive Group, Inc. (NYSE:PAG) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Penske Automotive Group

What Is Penske Automotive Group's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Penske Automotive Group had debt of US$4.23b, up from US$3.46b in one year. However, it also had US$92.3m in cash, and so its net debt is US$4.14b.

How Healthy Is Penske Automotive Group's Balance Sheet?

According to the last reported balance sheet, Penske Automotive Group had liabilities of US$4.31b due within 12 months, and liabilities of US$5.19b due beyond 12 months. Offsetting these obligations, it had cash of US$92.3m as well as receivables valued at US$831.3m due within 12 months. So it has liabilities totalling US$8.58b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$8.95b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Penske Automotive Group has a debt to EBITDA ratio of 2.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 15.2 is very high, suggesting that the interest expense on the debt is currently quite low. We note that Penske Automotive Group grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 Penske 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 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

Penske Automotive Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its level of total liabilities. All these things considered, it appears that Penske Automotive Group can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. We've identified 3 warning signs with Penske Automotive Group (at least 1 which is concerning) , and understanding them should be part of your investment process.

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.