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Does Penske Automotive Group (NYSE:PAG) Have A Healthy Balance Sheet?

Simply Wall St

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Penske Automotive Group, Inc. (NYSE:PAG) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Penske Automotive Group

How Much Debt Does Penske Automotive Group Carry?

The image below, which you can click on for greater detail, shows that at June 2019 Penske Automotive Group had debt of US$6.01b, up from US$5.76b in one year. And it doesn't have much cash, so its net debt is about the same.

NYSE:PAG Historical Debt, October 11th 2019

A Look At Penske Automotive Group's Liabilities

The latest balance sheet data shows that Penske Automotive Group had liabilities of US$5.17b due within a year, and liabilities of US$5.53b falling due after that. On the other hand, it had cash of US$43.8m and US$944.4m worth of receivables due within a year. So its liabilities total US$9.71b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$3.55b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt After all, Penske Automotive Group would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Penske Automotive Group has a rather high debt to EBITDA ratio of 8.1 which suggests a meaningful debt load. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. More concerning, Penske Automotive Group saw its EBIT drop by 3.5% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Penske Automotive Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Penske Automotive Group's free cash flow amounted to 48% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Penske Automotive Group's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. Overall, it seems to us that Penske Automotive Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our concerns about Penske Automotive Group's debt levels, it seems only prudent to check if insiders have been ditching the stock.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.