American Woodmark (NASDAQ:AMWD) Seems To Use Debt Quite Sensibly

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 American Woodmark Corporation (NASDAQ:AMWD) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for American Woodmark

What Is American Woodmark's Net Debt?

You can click the graphic below for the historical numbers, but it shows that American Woodmark had US$369.4m of debt in April 2023, down from US$504.0m, one year before. On the flip side, it has US$41.7m in cash leading to net debt of about US$327.7m.

How Healthy Is American Woodmark's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that American Woodmark had liabilities of US$178.1m due within 12 months and liabilities of US$466.9m due beyond that. Offsetting these obligations, it had cash of US$41.7m as well as receivables valued at US$119.2m due within 12 months. So it has liabilities totalling US$484.1m more than its cash and near-term receivables, combined.

This deficit isn't so bad because American Woodmark is worth US$1.20b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

American Woodmark has net debt of just 1.4 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.6 times the interest expense over the last year. Even more impressive was the fact that American Woodmark grew its EBIT by 279% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if American Woodmark 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, American Woodmark generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, American Woodmark's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think American Woodmark's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. We'd be motivated to research the stock further if we found out that American Woodmark insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.