Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We can see that Sonic Automobile, Inc. (NYSE: SAH) uses debt in its business. But the most important question is: what risk does this debt create?
When Is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company can’t meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
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What is Sonic Automotive’s net debt?
As you can see below, Sonic Automotive had $ 1.77 billion in debt in June 2021, up from $ 1.97 billion the year before. However, he also had $ 314.6 million in cash, so his net debt is $ 1.46 billion.
How healthy is Sonic Automotive’s track record?
According to the latest published balance sheet, Sonic Automotive had liabilities of US $ 1.64 billion due within 12 months and liabilities of US $ 1.07 billion due beyond 12 months. In return, he had $ 314.6 million in cash and $ 356.9 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by US $ 2.04 billion.
This deficit is substantial compared to its market capitalization of US $ 2.21 billion, so he suggests shareholders keep an eye on Sonic Automotive’s use of debt. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
We measure a company’s debt load relative to its earning capacity 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 costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Sonic Automotive has a net debt to EBITDA of 2.7, which suggests that it uses good leverage to increase returns. But the high interest coverage of 7.5 suggests that he can easily pay off that debt. It should be noted that Sonic Automotive’s EBIT has soared like bamboo after the rain, gaining 65% in the past twelve months. This will make it easier to manage your debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, 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 analyst earnings forecast report interesting.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly verify whether this EBIT generates a corresponding free cash flow. Over the past three years, Sonic Automotive has generated free cash flow of 14% of its EBIT, a performance that is without interest. For us, the conversion to cash that elicits a bit of paranoia is the ability to extinguish debt.
Our point of view
Neither Sonic Automotive’s ability to manage its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is that he seems to be able to increase his EBIT with ease. We think Sonic Automotive’s debt makes it a bit risky, having looked at the aforementioned data points together. Not all risks are bad, as they can increase stock price returns if they are profitable, but this risk of leverage is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we have identified 1 warning sign for Sonic Automotive that you need to be aware of.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page. free list of growing companies that have net cash on the balance sheet.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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