Is American Woodmark (NASDAQ:AMWD) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, American Woodmark Corporation (NASDAQ:AMWD) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out the opportunities and risks within the US Building industry.

How Much Debt Does American Woodmark Carry?

As you can see below, American Woodmark had US$486.4m of debt, at July 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$33.7m in cash, and so its net debt is US$452.7m.

How Healthy Is American Woodmark's Balance Sheet?

According to the last reported balance sheet, American Woodmark had liabilities of US$236.9m due within 12 months, and liabilities of US$616.8m due beyond 12 months. On the other hand, it had cash of US$33.7m and US$162.4m worth of receivables due within a year. So its liabilities total US$657.5m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$840.4m, so it does suggest shareholders should keep an eye on American Woodmark's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

American Woodmark's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 5.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, American Woodmark's EBIT fell a jaw-dropping 38% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, American Woodmark produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

American Woodmark's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. Taking the abovementioned factors together we do think American Woodmark's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for American Woodmark you should know about.

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.

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.