Li Lu, an external fund manager backed by Berkshire Hathaway's Charlie Munger, says, “The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.'' It has even been stated. When we think about a company's risk, we always look at its use of debt. Because too much debt can lead to ruin. the important thing is, Sonic Automotive Co., Ltd. (NYSE:SAH) has debt. But the real question is whether this debt is putting the company at risk.
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it is at their mercy. Part of capitalism is the process of “creative destruction” in which failing companies are ruthlessly liquidated by bankers. But a more frequent (but still costly) occurrence is when a company must issue stock at a bargain price, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is one in which a company manages its debt reasonably well and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Sonic Automotive.
What is Sonic Automotive's net debt?
You can click on the image below for greater detail, but as of September 2023, Sonic Automotive had debt of US$3.07b, up from US$2.58b in one year. However, it did have US$336.7m in cash offsetting this, leading to its net debt of approximately US$2.73b.
How strong is Sonic Automotive's balance sheet?
Zooming in on the latest balance sheet data, we can see that Sonic Automotive had liabilities of US$2.01b due within 12 months, and liabilities of US$2.18b due beyond that. Offsetting this, it had cash of US$336.7m and his receivables of US$431.5m due within 12 months. So its total liabilities total US$3.42b more than its cash and short-term receivables, combined.
The deficit looms over the $1.94 billion company like a colossus towering over humans. So we will definitely be keeping a close eye on its balance sheet. After all, if creditors demand repayment, Sonic Automotive will likely need a major recapitalization.
We use two main ratios to determine debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), and the second is how much earnings before interest and tax (EBIT) covers interest expense (or interest cover, for short). It's about how many times you cover it. . This way, we consider both the absolute amount of debt and the interest rate paid on it.
Sonic Automotive has a debt-to-EBITDA ratio of 4.0, with its EBIT covering its interest expense 3.3 times. Taken together, this means that while we don't want higher debt levels, we think the current leverage can be managed. Even more troubling is the fact that Sonic Automotive actually saw its EBIT decrease by 8.1% in the last year. At this rate, paying off your debt is like running on a treadmill, and you won't make much progress even if you put in a lot of effort. There's no question that we learn most about debt from the balance sheet. But more than anything else, future earnings will determine whether Sonic Automotive can maintain a healthy balance sheet going forward. So if you want to see what the experts think, you might find this free report on analyst profit forecasts to be interesting.
Finally, companies can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of his EBIT that is matched by actual free cash flow. Looking at the most recent three years, Sonic Automotive's free cash flow was 46% of his EBIT, which was lower than expected. This weak cash conversion makes dealing with debt even more difficult.
our view
We'd go so far as to say that Sonic Automotive's total debt levels were disappointing. But at least the conversion of EBIT to free cash flow isn't too bad. We've been clear that we think Sonic Automotive is actually quite risky as a result of the strength of its balance sheet. In short, we're as wary of this stock as we are of a hungry kitten falling into its owner's fish pond. As the saying goes, once bitten, twice shy. The balance sheet is clearly the area to focus on when analyzing debt. Ultimately, however, any company can contain risks that exist outside the balance sheet.For example, Sonic Automotive has two warning signs I think you should know.
If you're more interested in fast-growing companies with rock-solid balance sheets, then check out our list of net cash growth stocks without delay.
Valuation is complex, but we help make it simple.
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This article by Simply Wall St is general in nature. We provide commentary using only unbiased methodologies, based on historical data and analyst forecasts, and articles are not intended to be financial advice. This is not a recommendation to buy or sell any stock, and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on fundamental data. Note that our analysis may not factor in the latest announcements or qualitative material from price-sensitive companies. Simply Wall St has no position in any stocks mentioned.
