Does A. O. Smith (NYSE:AOS) Have A Healthy Balance Sheet?

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.' 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 the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

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What Is A. O. Smith's Net Debt?

As you can see below, at the end of June 2022, A. O. Smith had US$298.4m of debt, up from US$106.4m a year ago. Click the image for more detail. But on the other hand it also has US$459.4m in cash, leading to a US$161.0m net cash position.

A Look At A. O. Smith's Liabilities

We can see from the most recent balance sheet that A. O. Smith had liabilities of US$928.3m falling due within a year, and liabilities of US$600.6m due beyond that. Offsetting this, it had US$459.4m in cash and US$621.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$448.0m.

Of course, A. O. Smith has a market capitalization of US$8.02b, 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. 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.

Also good is that A. O. Smith grew its EBIT at 18% over the last year, further increasing its ability to manage 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're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, A. O. Smith recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that A. O. Smith has US$161.0m in net cash. The cherry on top was that in converted 87% of that EBIT to free cash flow, bringing in US$424m. So is A. O. Smith's debt a risk? It doesn't seem so to us. 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.

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.

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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.