David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies A. O. Smith Corporation (NYSE:AOS) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 examine debt levels, we first consider both cash and debt levels, together.
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$281.1m of debt in June 2020, down from US$358.6m, one year before. But on the other hand it also has US$568.7m in cash, leading to a US$287.6m net cash position.
How Healthy Is A. O. Smith's Balance Sheet?
The latest balance sheet data shows that A. O. Smith had liabilities of US$735.4m due within a year, and liabilities of US$590.7m falling due after that. Offsetting this, it had US$568.7m in cash and US$515.9m in receivables that were due within 12 months. So its liabilities total US$241.5m more than the combination of its cash and short-term receivables.
Of course, A. O. Smith has a market capitalization of US$7.90b, 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. Despite its noteworthy liabilities, A. O. Smith boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact A. O. Smith's saving grace is its low debt levels, because its EBIT has tanked 27% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if A. O. Smith 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 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 most recent three years, A. O. Smith recorded free cash flow worth 76% 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.
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$287.6m. And it impressed us with free cash flow of US$439m, being 76% of its EBIT. So we are not troubled with A. O. Smith's debt use. 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 A. O. Smith .
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.
This article by Simply Wall St is general in nature. 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email firstname.lastname@example.org.