Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ While understanding the risks associated with debt is crucial when assessing a company’s financial health, it’s essential to consider the context. Sonic Automotive, Inc. (NYSE:SAH) does have debt on its balance sheet, but should investors be concerned about it?
In general, the real problem with debt arises when a company is unable to repay it, either by raising capital or generating sufficient cash flow. This can lead to significant consequences, with shareholders potentially losing everything. Another costly scenario is when a company has to issue shares at greatly reduced prices, consequently diluting the ownership of current shareholders. However, debt can provide cheap capital for a company, particularly when it allows for reinvestment at high rates of return.
A good starting point when evaluating a company’s debt is to analyze its cash position and overall debt together. As of June 2023, Sonic Automotive had a debt of US$3.10 billion, up from US$2.77 billion in the previous year. However, it also had US$406.7 million in cash, resulting in net debt of approximately US$2.69 billion.
A closer look at Sonic Automotive’s balance sheet reveals that it had liabilities of US$2.00 billion due within a year, with an additional US$2.20 billion due beyond that. Offsetting this, the company had US$406.7 million in cash and US$400.6 million in receivables due within 12 months. Overall, Sonic Automotive’s liabilities exceeded its cash and near-term receivables by US$3.40 billion. This deficit raises concerns about the company’s ability to meet its obligations, potentially requiring significant recapitalization if creditors demand repayment.
To assess the company’s debt relative to its earnings, it’s important to calculate its net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), as well as its EBIT divided by its interest expense (interest cover). Sonic Automotive has a debt to EBITDA ratio of 3.9 and an interest cover of 3.6 times. While these debt levels are significant, they do not reach problematic levels.
However, there is cause for concern as Sonic Automotive witnessed a 3.7% drop in EBIT in the past year. If this trend continues, the company may face challenges in repaying its debt. The future profitability of the business will ultimately determine whether Sonic Automotive can strengthen its balance sheet over time.
In terms of liquidity, it’s important to assess how much of its EBIT is converted into free cash flow, as a company cannot pay its debt with paper profits. Over the last three years, Sonic Automotive’s free cash flow amounted to 45% of its EBIT, which is lower than expected. This raises questions about the company’s ability to pay down its debts.
Taking everything into account, Sonic Automotive’s high level of total liabilities poses a risk to the company. Investors should exercise caution and closely monitor its liquidity. While analyzing a company’s debt can provide valuable insights, it’s important to remember that risks can exist outside of the balance sheet as well.
Definitions:
– Debt: Money borrowed by a company that needs to be repaid.
– Balance Sheet: A financial statement that provides a snapshot of the company’s assets, liabilities, and shareholders’ equity at a specific point in time.
– Net Debt: The difference between a company’s total debt and its cash and cash equivalents.
– EBITDA: Earnings before interest, tax, depreciation, and amortization, a measure of a company’s operating performance.
– Interest Cover: The ratio that assesses a company’s ability to cover interest payments with its operating income.
Source: Simply Wall St