Is Sonic Automotive (NYSE:SAH) Using Too Much Debt?

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.' 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. We can see that Sonic Automotive, Inc. (NYSE:SAH) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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.

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 Sonic Automotive had debt of US$1.59b at the end of September 2021, a reduction from US$1.91b over a year. However, it does have US$320.1m in cash offsetting this, leading to net debt of about US$1.27b.

How Healthy Is Sonic Automotive's Balance Sheet?

According to the last reported balance sheet, Sonic Automotive had liabilities of US$1.43b due within 12 months, and liabilities of US$1.07b due beyond 12 months. Offsetting this, it had US$320.1m in cash and US$278.0m in receivables that were due within 12 months. So its liabilities total US$1.90b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$2.05b, so it does suggest shareholders should keep an eye on Sonic Automotive'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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sonic Automotive's net debt of 2.2 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.3 times its interest expenses harmonizes with that theme. It is well worth noting that Sonic Automotive's EBIT shot up like bamboo after rain, gaining 58% in the last twelve months. That'll make it easier to manage its 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 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Sonic Automotive recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Sonic Automotive's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Sonic Automotive is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 1 warning sign for Sonic Automotive 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.