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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
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How Much Debt Does Lithia Motors Carry?
As you can see below, at the end of June 2022, Lithia Motors had US$6.22b of debt, up from US$4.10b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is Lithia Motors’ Balance Sheet?
The latest balance sheet data shows that Lithia Motors had liabilities of US$2.61b due within a year, and liabilities of US$5.66b falling due after that. Offsetting this, it had US$113.2m in cash and US$978.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.18b.
When you consider that this deficiency exceeds the company’s US$6.59b market capitalization, you might well be inclined to review the balance sheet intently. 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.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Lithia Motors’s net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 14.7 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that Lithia Motors’s EBIT shot up like bamboo after rain, gaining 74% in the last twelve months. That’ll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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’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. Looking at the most recent three years, Lithia Motors recorded free cash flow of 46% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Our View
Lithia Motors’s interest cover was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. Looking at all this data makes us feel a little cautious about Lithia Motors’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 1 warning sign for Lithia Motors that you should be aware of.
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.
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