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 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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Penske Automotive Group’s Net Debt?
As you can see below, Penske Automotive Group had US$3.46b of debt at September 2021, down from US$4.83b a year prior. However, it also had US$119.2m in cash, and so its net debt is US$3.34b.
A Look At Penske Automotive Group’s Liabilities
We can see from the most recent balance sheet that Penske Automotive Group had liabilities of US$3.84b falling due within a year, and liabilities of US$5.02b due beyond that. Offsetting these obligations, it had cash of US$119.2m as well as receivables valued at US$737.7m due within 12 months. So it has liabilities totalling US$8.00b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$8.05b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Penske Automotive Group has a debt to EBITDA ratio of 2.6, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 10.1 times its interest expense, implying the company isn’t really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Penske Automotive Group grew its EBIT by 91% over the last twelve months, and that growth will make it easier to handle 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Penske Automotive Group generated free cash flow amounting to a very robust 100% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Our View
The good news is that Penske Automotive Group’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its level of total liabilities has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Penske Automotive Group can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt.