Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We note that O’Reilly Automotive, Inc. (NASDAQ: ORLY) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
When Is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
What is O’Reilly Automotive’s debt?
The image below, which you can click for more details, shows that O’Reilly Automotive was in debt of $ 3.83 billion at the end of June 2021, a reduction from $ 4.13 billion. of US dollars over one year. On the other hand, it has $ 631.6 million in cash, resulting in net debt of around $ 3.19 billion.
NasdaqGS: ORLY History of debt to equity October 25, 2021
How strong is O’Reilly Automotive’s balance sheet?
Zooming in on the latest balance sheet data, we can see that O’Reilly Automotive had $ 5.77 billion in liabilities due within 12 months and $ 5.96 billion in liabilities due beyond. In return, he had $ 631.6 million in cash and $ 386.3 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by $ 10.7 billion.
While that might sound like a lot, it’s not that bad as O’Reilly Automotive has a massive market cap of US $ 45.8 billion, and therefore could likely strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
O’Reilly Automotive’s net debt is only 1.0 times its EBITDA. And its EBIT easily covers its interest costs, being 18.0 times higher. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Also positive, O’Reilly Automotive has increased its EBIT by 28% over the past year, which should make it easier to pay down debt going forward. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine O’Reilly 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 analyst earnings forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, O’Reilly Automotive has recorded free cash flow totaling 82% of its EBIT, which is higher than what we normally expect. This puts him in a very strong position to pay off the debt.
Our point of view
Fortunately, O’Reilly Automotive’s impressive interest coverage means it has the upper hand on its debt. And this is only the beginning of good news as its conversion from EBIT to free cash flow is also very encouraging. Overall, we don’t think O’Reilly Automotive is taking bad risks, as its leverage appears modest. The balance sheet therefore seems rather healthy to us. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 2 warning signs for O’Reilly Automotive which you should know before investing here.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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