David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that carsales.com Ltd (ASX:CAR) has debt on its balance sheet. But should shareholders worry about its use of debt?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for carsales.com
What is carsales.com Net Debt?
As you can see below, at the end of December 2021, carsales.com had A$643.2 million in debt, up from A$467.2 million a year ago. Click on the image for more details. However, he also had A$90.7 million in cash, so his net debt is A$552.5 million.
How strong is carsales.com’s balance sheet?
We can see from the most recent balance sheet that carsales.com had liabilities of A$101.0m due within a year, and liabilities of A$730.2m due beyond . On the other hand, it had cash of A$90.7 million and A$52.0 million of receivables due within one year. It therefore has liabilities totaling A$688.5 million more than its cash and short-term receivables, combined.
Given that publicly traded carsales.com shares are worth a total of A$5.29 billion, it seems unlikely that this level of liability is a major threat. That said, it is clear that we must continue to monitor its record, lest it deteriorate.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
We would say carsales.com’s moderate net debt to EBITDA ratio (2.4) is an indication of leverage caution. And its strong interest coverage of 30.6 times makes us even more comfortable. We note that carsales.com has grown its EBIT by 21% over the past year, which should make it easier to pay down debt in the future. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether carsales.com can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cold hard cash, not with book profits. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, carsales.com has produced strong free cash flow equivalent to 79% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Fortunately, carsales.com’s impressive interest coverage means it has the upper hand on its debt. But, on a darker note, we’re a bit concerned about its net debt to EBITDA. Zooming out, carsales.com seems to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 2 warning signs for carsales.com you should be aware.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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