Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Eagers Automotive Limited (ASX:APE) makes use of debt. But should shareholders be worried about its use of debt?

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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. 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. 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.

What Is Eagers Automotive's Debt?

As you can see below, at the end of December 2024, Eagers Automotive had AU$2.52b of debt, up from AU$1.80b a year ago. Click the image for more detail. However, it does have AU$183.7m in cash offsetting this, leading to net debt of about AU$2.33b.

How Healthy Is Eagers Automotive's Balance Sheet?

According to the last reported balance sheet, Eagers Automotive had liabilities of AU$2.42b due within 12 months, and liabilities of AU$1.68b due beyond 12 months. On the other hand, it had cash of AU$183.7m and AU$361.6m worth of receivables due within a year. So its liabilities total AU$3.56b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of AU$3.87b, so it does suggest shareholders should keep an eye on Eagers Automotive's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

View our latest analysis for Eagers Automotive

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.

Eagers Automotive's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Given the debt load, it's hardly ideal that Eagers Automotive's EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Eagers Automotive's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Eagers Automotive recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Eagers Automotive's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Eagers Automotive stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Eagers Automotive (1 shouldn't be ignored!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.