We Think A. O. Smith (NYSE:AOS) Can Manage Its Debt With Ease

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 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 more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View 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 at December 2022 A. O. Smith had debt of US$344.5m, up from US$196.7m in one year. But it also has US$481.8m in cash to offset that, meaning it has US$137.3m net cash.

How Healthy 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$934.2m due within 12 months and liabilities of US$650.4m due beyond that. Offsetting this, it had US$481.8m in cash and US$581.2m in receivables that were due within 12 months. So it has liabilities totalling US$521.6m more than its cash and near-term receivables, combined.

Given A. O. Smith has a humongous market capitalization of US$10.2b, 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. 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.

The good news is that A. O. Smith has increased its EBIT by 8.2% over twelve months, which should ease any concerns about debt repayment. 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, a company can only pay off debt with cold hard cash, not accounting profits. While A. O. Smith has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, A. O. Smith recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

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$137.3m. And it impressed us with free cash flow of US$321m, being 81% of its EBIT. So we don't think A. O. Smith's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for A. O. Smith that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.