Is A. O. Smith (NYSE:AOS) A Risky Investment?

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.' 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 is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for A. O. Smith

How Much Debt Does A. O. Smith Carry?

The image below, which you can click on for greater detail, shows that A. O. Smith had debt of US$129.6m at the end of September 2023, a reduction from US$287.8m over a year. However, its balance sheet shows it holds US$341.8m in cash, so it actually has US$212.2m net cash.

A Look At A. O. Smith's Liabilities

The latest balance sheet data shows that A. O. Smith had liabilities of US$895.6m due within a year, and liabilities of US$422.1m falling due after that. Offsetting these obligations, it had cash of US$341.8m as well as receivables valued at US$587.4m due within 12 months. So its liabilities total US$388.5m more than the combination of its cash and short-term receivables.

Given A. O. Smith has a humongous market capitalization of US$11.3b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, A. O. Smith boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that A. O. Smith grew its EBIT by 14% last year, making its debt load easier to handle. 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 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 most recent three years, A. O. Smith recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

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$212.2m. The cherry on top was that in converted 77% of that EBIT to free cash flow, bringing in US$554m. So is A. O. Smith's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - A. O. Smith has 3 warning signs we think you should be aware of.

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.

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.