Here's Why Lithia Motors (NYSE:LAD) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Lithia Motors, Inc. (NYSE:LAD) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Lithia Motors

What Is Lithia Motors's Net Debt?

As you can see below, at the end of December 2022, Lithia Motors had US$7.59b of debt, up from US$4.55b a year ago. Click the image for more detail. However, it also had US$246.7m in cash, and so its net debt is US$7.34b.

How Healthy Is Lithia Motors' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Lithia Motors had liabilities of US$3.18b due within 12 months and liabilities of US$6.58b due beyond that. Offsetting these obligations, it had cash of US$246.7m as well as receivables valued at US$846.7m due within 12 months. So it has liabilities totalling US$8.66b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$5.81b, we think shareholders really should watch Lithia Motors'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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Lithia Motors has a debt to EBITDA ratio of 3.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 11.7 is very high, suggesting that the interest expense on the debt is currently quite low. One way Lithia Motors could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Lithia Motors 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Lithia Motors's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Lithia Motors's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Lithia Motors's debt is making it 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 - Lithia Motors has 2 warning signs we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.