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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Cars.com Inc. (NYSE:CARS) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Cars.com's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Cars.com had debt of US$473.8m, up from US$454.2m in one year. However, it also had US$31.4m in cash, and so its net debt is US$442.4m.

A Look At Cars.com's Liabilities

According to the last reported balance sheet, Cars.com had liabilities of US$109.4m due within 12 months, and liabilities of US$552.3m due beyond 12 months. Offsetting this, it had US$31.4m in cash and US$125.7m in receivables that were due within 12 months. So it has liabilities totalling US$504.6m more than its cash and near-term receivables, combined.

Cars.com has a market capitalization of US$1.13b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Cars.com's net debt to EBITDA ratio of 2.8, we think its super-low interest cover of 1.7 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that Cars.com saw its EBIT drop by 18% 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Cars.com can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Cars.com actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Cars.com's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Cars.com's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 3 warning signs we've spotted with Cars.com (including 1 which is a bit unpleasant) .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.