Here's Why Sonic Automotive (NYSE:SAH) Is Weighed Down By Its Debt Load

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

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out 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 2024 Sonic Automotive had debt of US$3.53b, up from US$3.07b in one year. However, it also had US$417.6m in cash, and so its net debt is US$3.11b.

A Look At Sonic Automotive's Liabilities

According to the last reported balance sheet, Sonic Automotive had liabilities of US$2.54b due within 12 months, and liabilities of US$2.20b due beyond 12 months. Offsetting these obligations, it had cash of US$417.6m as well as receivables valued at US$436.6m due within 12 months. So its liabilities total US$3.89b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$2.54b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Sonic Automotive would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Sonic Automotive shareholders face the double whammy of a high net debt to EBITDA ratio (5.3), and fairly weak interest coverage, since EBIT is just 2.3 times the interest expense. The debt burden here is substantial. Investors should also be troubled by the fact that Sonic Automotive saw its EBIT drop by 19% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Sonic Automotive's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Sonic Automotive's level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. After considering the datapoints discussed, we think Sonic Automotive has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Sonic Automotive (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.