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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies AutoNation, Inc. (NYSE:AN) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

How Much Debt Does AutoNation Carry?

The image below, which you can click on for greater detail, shows that at March 2024 AutoNation had debt of US$7.13b, up from US$5.98b in one year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is AutoNation's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that AutoNation had liabilities of US$5.38b due within 12 months and liabilities of US$4.30b due beyond that. Offsetting these obligations, it had cash of US$60.3m as well as receivables valued at US$477.2m due within 12 months. So its liabilities total US$9.14b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$6.86b, we think shareholders really should watch AutoNation's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

AutoNation's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 4.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Investors should also be troubled by the fact that AutoNation saw its EBIT drop by 20% over the last twelve months. 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 AutoNation 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. During the last three years, AutoNation produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both AutoNation's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Overall, it seems to us that AutoNation's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for AutoNation (1 makes us a bit uncomfortable) you should be aware of.

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.

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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.