Is Lithia Motors (NYSE:LAD) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Lithia Motors, Inc. (NYSE:LAD) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Lithia Motors

How Much Debt Does Lithia Motors Carry?

The image below, which you can click on for greater detail, shows that at December 2024 Lithia Motors had debt of US$12.0b, up from US$10.8b in one year. However, because it has a cash reserve of US$402.2m, its net debt is less, at about US$11.6b.

How Strong Is Lithia Motors' Balance Sheet?

The latest balance sheet data shows that Lithia Motors had liabilities of US$6.55b due within a year, and liabilities of US$9.90b falling due after that. Offsetting this, it had US$402.2m in cash and US$1.24b in receivables that were due within 12 months. So its liabilities total US$14.8b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$9.82b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Lithia Motors would probably need a major re-capitalization if its creditors were to demand repayment.

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 rather high debt to EBITDA ratio of 6.2 which suggests a meaningful debt load. However, its interest coverage of 3.0 is reasonably strong, which is a good sign. More concerning, Lithia Motors saw its EBIT drop by 8.7% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Lithia Motors'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 report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Lithia Motors saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Lithia Motors's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. Considering all the factors previously mentioned, we think that Lithia Motors really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Lithia Motors has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.