Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies carsales.com Ltd (ASX:CAR) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does carsales.com Carry?
As you can see below, carsales.com had AU$43.2m of debt at June 2021, down from AU$558.4m a year prior. But it also has AU$284.0m in cash to offset that, meaning it has AU$240.8m net cash.
A Look At carsales.com's Liabilities
The latest balance sheet data shows that carsales.com had liabilities of AU$86.2m due within a year, and liabilities of AU$136.9m falling due after that. Offsetting these obligations, it had cash of AU$284.0m as well as receivables valued at AU$42.7m due within 12 months. So it can boast AU$103.6m more liquid assets than total liabilities.
This state of affairs indicates that carsales.com's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the AU$6.94b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that carsales.com has more cash than debt is arguably a good indication that it can manage its debt safely.
Also positive, carsales.com grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine carsales.com'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. While carsales.com has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, carsales.com generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that carsales.com has net cash of AU$240.8m, as well as more liquid assets than liabilities. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in AU$165m. So we don't think carsales.com's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with carsales.com .
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.
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.
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