We Think A. O. Smith (NYSE:AOS) Can Stay On Top Of Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that A. O. Smith Corporation (NYSE:AOS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for A. O. Smith

What Is A. O. Smith's Debt?

You can click the graphic below for the historical numbers, but it shows that A. O. Smith had US$119.7m of debt in September 2024, down from US$129.6m, one year before. However, it does have US$255.6m in cash offsetting this, leading to net cash of US$135.9m.

How Strong Is A. O. Smith's Balance Sheet?

We can see from the most recent balance sheet that A. O. Smith had liabilities of US$844.2m falling due within a year, and liabilities of US$393.3m due beyond that. Offsetting these obligations, it had cash of US$255.6m as well as receivables valued at US$558.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$423.7m.

Of course, A. O. Smith has a titanic market capitalization of US$10.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, A. O. Smith boasts net cash, so it's fair to say it does not have a heavy debt load!

A. O. Smith's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

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$135.9m. And it impressed us with free cash flow of US$484m, being 69% of its EBIT. So we don't think A. O. Smith's use of debt is risky. Over time, share prices tend to follow earnings per share, so if you're interested in A. O. Smith, you may well want to click here to check an interactive graph of its earnings per share history.

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.