Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Autosports Group Limited (ASX:ASG) makes use of debt. But the real question is whether this debt is making the company risky.
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where 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.
What Is Autosports Group's Debt?
As you can see below, Autosports Group had AU$483.8m of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. However, it does have AU$11.7m in cash offsetting this, leading to net debt of about AU$472.1m.
How Healthy Is Autosports Group's Balance Sheet?
The latest balance sheet data shows that Autosports Group had liabilities of AU$512.6m due within a year, and liabilities of AU$70.5m falling due after that. On the other hand, it had cash of AU$11.7m and AU$78.1m worth of receivables due within a year. So its liabilities total AU$493.3m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the AU$241.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Autosports 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Autosports Group has a rather high debt to EBITDA ratio of 8.3 which suggests a meaningful debt load. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. Another concern for investors might be that Autosports Group's EBIT fell 15% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Autosports Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Autosports Group's free cash flow amounted to 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
On the face of it, Autosports 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. And even its interest cover fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Autosports Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Autosports Group's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.