Is Watsco (NYSE:WSO) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Watsco, Inc. (NYSE:WSO) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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 as of September 2023 Watsco had US$105.6m of debt, an increase on US$8.80m, over one year. But it also has US$175.0m in cash to offset that, meaning it has US$69.4m net cash.

How Strong Is Watsco's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Watsco had liabilities of US$887.6m due within 12 months and liabilities of US$485.7m due beyond that. On the other hand, it had cash of US$175.0m and US$949.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$249.0m.

This state of affairs indicates that Watsco's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$14.6b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Watsco boasts net cash, so it's fair to say it does not have a heavy debt load!

Watsco'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. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Watsco'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Watsco 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. During the last three years, Watsco produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Watsco has US$69.4m in net cash. So we don't think Watsco's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign 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.