This article is the first in a series of articles that will provide readers with helpful pointers on investing in Detroit’s largest industry – the automotive sector. This article will focus on Total Debt-to-Cash Flow, one of the key ratios in determining the financial health of an automotive company.
Why it’s important
This ratio measures whether or not the company’s operations are generating an amount of cash that is healthy enough to support its debt obligations. This is important because generally, auto sector companies are capital intensive and highly leveraged.
This means that auto sector companies need to invest heavily in property, plant and equipment. The accounting for these items creates expenses on the income statement that do not represent a use of cash flow. To finance these items, auto sector companies usually take on a significant amount of debt.
The financial numbers needed to perform this analysis are found in quarterly (called a form 10Q) and annual (called a form 10K) financial statements which are filed with the Securities and Exchange Commission (SEC). All publically traded companies must file these documents which are freely available on the SEC’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) website.
The numerator – total debt defined
Total debt includes short-term, current maturities, long-term and off-balance sheet debt. These numbers are usually available in the company’s quarterly and annual financial statements, though you will need to look into the footnotes for the off-balance sheet debt, in particular, accounts receivable securitization programs, also known as factoring.
Factoring, which in effect is a more cost effective means of short term financing, enables automotive suppliers to sell their receivables to a third party at a discount. Some auto sector companies heavily rely on these financing vehicles to provide funds to meet working capital requirements. Since factoring is such an integral part of many companies’ capital structures, it makes sense to include any outstanding balances as a part of a total debt calculation.
The denominator – cash flow defined
The amount of cash being generated from a company’s manufacturing operations is not readily apparent from financial statements created in accordance with Generally Accepted Accounting Principles (GAAP). Cash flow has many different definitions and seasoned investors might tweak the definition to suit their individual needs. For this analysis, the cash flow measure called ‘Earnings before Interest, Depreciation and Amortization’ (EBITDA) will be used.
‘Operating income’ from the income statement can include non-cash items such as depreciation, amortization, restructuring charges and asset impairment charges. ‘Cash flow from operating activities’ includes changes in working capital and cash from AR programs. Even though these items are necessary for the smooth operation of day-to-day manufacturing activities, cash flow from working capital can expand and contract from issues outside of operations and, as discussed above, factoring acts more like short-term financing.
EBITDA can be calculated in more than one way but for this analysis, operating income will be the starting point. First, operating income should be adjusted for any gains or charges that are one-time in nature and not reoccurring. For many auto sector companies, charges can be a normal part of operating expenses since the industry’s manufacturing base is continually changing.
Investors should thoroughly search the income statement, cash flow statement and the financial statement footnotes for items such as restructuring, asset impairment, sale of assets, or special items that may be included in operating income. Once all one-time gains and charges have been totaled, if there is a net gain, it should be subtracted and if the net amount is a charge it should be added to derive adjusted operating income.
Next, depreciation and amortization should be added to adjusted operating income to get EBITDA. If these numbers are not available on the income statement, then search in the operating section of the cash flow statement or in the financial statement footnotes.
What does the ratio’s result mean?
The total debt-to-EBITDA ratio is a way to compare a company’s debt burden, to other companies within a peer group. Generally, automotive companies with a total debt-to-EBITDA ratio within a range of 2.3 times(x) and 2.7x, have a tolerable but high amount of financial leverage relative to the amount of cash generated by its operations. If the ratio is any higher, then the company may have an excessive debt burden.
Investors should not only consider what the ratio is saying about the company’s current situation but also, what the ratio might look like in the next few quarters. If a company’s operations have been improving due to higher volume or increased manufacturing efficiency, then the ratio may improve (go down) due to higher EBITDA or even debt reduction from excess cash. Contrarily, if a company’s volume or manufacturing efficiency is expected to decline, the ratio may worsen (go up) due to less EBITDA or additional borrowing needed to support operating costs.