Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that A. O. Smith Corporation (NYSE:AOS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is A. O. Smith's Net Debt?
You can click the graphic below for the historical numbers, but it shows that A. O. Smith had US$106.4m of debt in June 2021, down from US$281.1m, one year before. However, its balance sheet shows it holds US$581.9m in cash, so it actually has US$475.5m net cash.
A Look At A. O. Smith's Liabilities
According to the last reported balance sheet, A. O. Smith had liabilities of US$907.0m due within 12 months, and liabilities of US$416.9m due beyond 12 months. Offsetting these obligations, it had cash of US$581.9m as well as receivables valued at US$607.0m due within 12 months. So it has liabilities totalling US$135.0m more than its cash and near-term receivables, combined.
Having regard to A. O. Smith's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$11.2b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, A. O. Smith also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, A. O. Smith grew its EBIT by 47% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. 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 last three years, A. O. Smith recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that A. O. Smith has US$475.5m in net cash. And it impressed us with free cash flow of US$516m, being 89% of its EBIT. So is A. O. Smith'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. For example, we've discovered 1 warning sign for A. O. Smith that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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