Here's Why A. O. Smith (NYSE:AOS) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 A. O. Smith Corporation (NYSE:AOS) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for A. O. Smith

What Is A. O. Smith's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2019 A. O. Smith had US$319.2m of debt, an increase on US$193, over one year. However, its balance sheet shows it holds US$513.8m in cash, so it actually has US$194.6m net cash.

How Strong Is A. O. Smith's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that A. O. Smith had liabilities of US$730.4m due within 12 months and liabilities of US$681.3m due beyond that. Offsetting these obligations, it had cash of US$513.8m as well as receivables valued at US$614.1m due within 12 months. So it has liabilities totalling US$283.8m more than its cash and near-term receivables, combined.

Of course, A. O. Smith has a market capitalization of US$7.72b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, A. O. Smith also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the other side of the story is that A. O. Smith saw its EBIT decline by 7.1% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 A. O. Smith 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 63% 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.

Summing up

We could understand if investors are concerned about A. O. Smith's liabilities, but we can be reassured by the fact it has has net cash of US$194.6m. So we are not troubled with A. O. Smith's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that A. O. Smith insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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