Watsco (NYSE:WSO) Could Easily Take On More Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Watsco, Inc. (NYSE:WSO) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Watsco

What Is Watsco's Debt?

As you can see below, at the end of September 2021, Watsco had US$1.72m of debt, up from US$668.0k a year ago. Click the image for more detail. But it also has US$137.2m in cash to offset that, meaning it has US$135.5m 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$796.7m due within 12 months and liabilities of US$272.7m due beyond that. Offsetting this, it had US$137.2m in cash and US$771.0m in receivables that were due within 12 months. So it has liabilities totalling US$161.2m more than its cash and near-term receivables, combined.

Having regard to Watsco's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$10.8b 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!

In addition to that, we're happy to report that Watsco has boosted its EBIT by 50%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Watsco can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Watsco 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, Watsco recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Watsco has US$135.5m in net cash. And it impressed us with free cash flow of US$460m, being 95% of its EBIT. So is Watsco'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. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Watsco you should be aware of.

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.

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.

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