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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. Importantly, A. O. Smith Corporation (NYSE:AOS) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does A. O. Smith Carry?
You can click the graphic below for the historical numbers, but it shows that A. O. Smith had US$281.1m of debt in June 2020, down from US$358.6m, one year before. But it also has US$568.7m in cash to offset that, meaning it has US$287.6m net cash.
A Look At A. O. Smith’s Liabilities
According to the last reported balance sheet, A. O. Smith had liabilities of US$735.4m due within 12 months, and liabilities of US$590.7m due beyond 12 months. Offsetting this, it had US$568.7m in cash and US$515.9m in receivables that were due within 12 months. So it has liabilities totalling US$241.5m more than its cash and near-term receivables, combined.
Of course, A. O. Smith has a market capitalization of US$7.93b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, A. O. Smith boasts net cash, so it’s fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for A. O. Smith if management cannot prevent a repeat of the 27% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if A. O. Smith 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 company can only pay off debt with cold hard cash, not accounting profits. While A. O. Smith has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, A. O. Smith recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company’s total liabilities, it is very reassuring that A. O. Smith has US$287.6m in net cash. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in US$439m. So we don’t have any problem with A. O. Smith’s use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – A. O. Smith has 1 warning sign 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. 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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