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 A. O. Smith Corporation (NYSE:AOS) does use debt in its business. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is A. O. Smith's Net Debt?
As you can see below, A. O. Smith had US$106.4m of debt at June 2021, down from US$281.1m a year prior. However, it does have US$581.9m in cash offsetting this, leading to net cash of US$475.5m.
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$907.0m due within 12 months and liabilities of US$416.9m due beyond that. Offsetting these obligations, it had cash of US$581.9m as well as receivables valued at US$607.0m due within 12 months. So it has liabilities totalling US$135.0m more than its cash and near-term receivables, combined.
Having regard to A. O. Smith's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$10.9b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, A. O. Smith boasts net cash, so it's fair to say it does not have a heavy debt load!
On top of that, A. O. Smith grew its EBIT by 47% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine A. O. Smith's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. A. O. Smith may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, A. O. Smith generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to look at a company's total liabilities, it is very reassuring that A. O. Smith has US$475.5m in net cash. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in US$516m. So we don't think A. O. Smith's use of debt is risky. Another factor that would give us confidence in A. O. Smith would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
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. 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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