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 America's Car-Mart, Inc. (NASDAQ:CRMT) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is America's Car-Mart's Debt?
The chart below, which you can click on for greater detail, shows that America's Car-Mart had US$157.8m in debt in July 2019; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
How Strong Is America's Car-Mart's Balance Sheet?
We can see from the most recent balance sheet that America's Car-Mart had liabilities of US$32.9m falling due within a year, and liabilities of US$242.9m due beyond that. On the other hand, it had cash of US$1.64m and US$431.6m worth of receivables due within a year. So it can boast US$157.5m more liquid assets than total liabilities.
This excess liquidity suggests that America's Car-Mart is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.
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.
America's Car-Mart's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.2 times interest expense) certainly does not do anything to dispel this impression. It is well worth noting that America's Car-Mart's EBIT shot up like bamboo after rain, gaining 57% in the last twelve months. That'll make it easier to manage its debt. 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 America's Car-Mart'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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, America's Car-Mart's free cash flow amounted to 24% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
America's Car-Mart's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think America's Car-Mart's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. We'd be motivated to research the stock further if we found out that America's Car-Mart insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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