Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, AutoNation, Inc. (NYSE:AN) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does AutoNation Carry?
You can click the graphic below for the historical numbers, but it shows that AutoNation had US$6.01b of debt in June 2019, down from US$6.50b, one year before. And it doesn't have much cash, so its net debt is about the same.
How Strong Is AutoNation's Balance Sheet?
According to the last reported balance sheet, AutoNation had liabilities of US$5.59b due within 12 months, and liabilities of US$2.23b due beyond 12 months. Offsetting this, it had US$51.1m in cash and US$393.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.37b.
This deficit casts a shadow over the US$4.34b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, AutoNation would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
AutoNation has a rather high debt to EBITDA ratio of 6.4 which suggests a meaningful debt load. However, its interest coverage of 3.0 is reasonably strong, which is a good sign. Even more troubling is the fact that AutoNation actually let its EBIT decrease by 3.2% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AutoNation 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, AutoNation's free cash flow amounted to 35% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, AutoNation'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. Taking into account all the aforementioned factors, it looks like AutoNation has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about AutoNation'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.
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