Does Sonic Automotive (NYSE:SAH) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Sonic Automotive, Inc. (NYSE:SAH) does carry debt. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sonic Automotive

What Is Sonic Automotive's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Sonic Automotive had debt of US$3.07b, up from US$2.58b in one year. However, it does have US$336.7m in cash offsetting this, leading to net debt of about US$2.73b.

How Strong Is Sonic Automotive's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sonic Automotive had liabilities of US$2.01b due within 12 months and liabilities of US$2.18b due beyond that. Offsetting this, it had US$336.7m in cash and US$431.5m in receivables that were due within 12 months. So its liabilities total US$3.42b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$1.94b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Sonic Automotive would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sonic Automotive has a debt to EBITDA ratio of 4.0 and its EBIT covered its interest expense 3.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Sonic Automotive actually let its EBIT decrease by 8.1% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sonic Automotive's ability to maintain a healthy balance sheet going forward. 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 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. Looking at the most recent three years, Sonic Automotive recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Sonic Automotive's level of total liabilities was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. We're quite clear that we consider Sonic Automotive to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 - Sonic Automotive has 2 warning signs we think you should be aware of.

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.