Is Watsco (NYSE:WSO) A Risky Investment?

Warren Buffett famously said, '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. We can see that Watsco, Inc. (NYSE:WSO) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Watsco

How Much Debt Does Watsco Carry?

You can click the graphic below for the historical numbers, but it shows that Watsco had US$197.6m of debt in March 2023, down from US$262.5m, one year before. However, it does have US$141.0m in cash offsetting this, leading to net debt of about US$56.6m.

How Strong Is Watsco's Balance Sheet?

The latest balance sheet data shows that Watsco had liabilities of US$953.1m due within a year, and liabilities of US$539.2m falling due after that. On the other hand, it had cash of US$141.0m and US$811.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$540.1m.

Of course, Watsco has a titanic market capitalization of US$13.7b, 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. Carrying virtually no net debt, Watsco has a very light debt load indeed.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Watsco has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.068 and EBIT of 362 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. And we also note warmly that Watsco grew its EBIT by 15% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Watsco 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Watsco produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Watsco's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think Watsco's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Watsco .

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.